Types of Inflation and Their Causes

Types of inflation: mechanisms and sources
Inflation can have various causes and mechanisms of development. Diagnosing the type of inflation is critically important for selecting appropriate economic policy measures and assessing investment consequences. Demand-pull inflation, cost-push inflation, and expectation-driven inflation require different approaches and have different implications for assets.

Demand-Pull Inflation

Demand-pull inflation arises when the aggregate demand in the economy exceeds the aggregate supply at current prices. Excessive demand leads to rising prices, as buyers compete for a limited quantity of goods and services. Causes of excessive demand include expansionary monetary policy (low interest rates, quantitative easing), stimulative fiscal policy (increased government spending, tax cuts), growth of private lending and consumer confidence, external factors (increase in export demand).

Demand-pull inflation is usually accompanied by economic growth, low unemployment, and a positive output gap. This is a “good” type of inflation in the sense that the economy is operating at full capacity. However, it requires tightening of monetary policy to prevent overheating.

The classic monetarist position states that “inflation is always and everywhere a monetary phenomenon.” From this point of view, sustained demand-pull inflation is possible only with excessive growth of the money supply.

Cost-Push Inflation

Cost-push inflation arises when increases in production costs force companies to raise prices in order to maintain profitability. Sources of rising costs can be increases in prices for raw materials and energy resources (oil shocks), wage growth exceeding productivity increases, weakening of the national currency (more expensive imports), increases in taxes and regulatory costs.

Cost-push inflation is often combined with slowing economic growth or recession, as rising costs squeeze profits and undermine purchasing power. This creates a dilemma for economic policy: tightening policy to fight inflation will worsen the recession; loosening policy to support the economy will intensify inflation.

Stagflation—a combination of stagnation (low growth or decline) and high inflation—is a typical result of strong supply shocks. A classic example is the oil crises of the 1970s.

Inflation Expectations

Inflation expectations play a key role in the inflation process. If economic agents expect high inflation in the future, they begin to act accordingly: workers demand wage increases, companies incorporate cost growth into prices, lenders demand higher nominal rates. These actions themselves create inflationary pressure, and expectations become a self-fulfilling prophecy.

Anchored inflation expectations—a situation where expectations are stable near the target level of inflation—are a key achievement of modern central banks. Anchored expectations allow the economy to absorb temporary price shocks more easily without embedding them into sustained inflation.

De-anchoring of expectations—their divergence from the target level—poses a serious threat. If expectations rise, painful policy tightening with recession and rising unemployment may be needed to anchor them back.

Deflation and Disinflation

Deflation is a sustained decrease in the overall level of prices (negative inflation). Deflation is dangerous for the economy, as it increases the real value of debts, postpones consumption and investment (why buy today if tomorrow will be cheaper), and lowers nominal incomes while nominal obligations remain unchanged.

Disinflation is a reduction in the rate of inflation (inflation remains positive, but decreases). Disinflation is usually the result of successful anti-inflationary policy and does not carry the risks associated with deflation.

Application for Investors

Diagnosing the type of inflation is critically important for investment decisions. Demand-pull inflation is usually favorable for equities (the economy is growing, profits are rising) and unfavorable for bonds (rates increase). Cost-push inflation is unfavorable for equities (margins are squeezed) and creates a mixed situation for bonds (inflation rises, but the economy weakens).

Monitoring inflation expectations allows risks of de-anchoring to be assessed. Growth in inflation expectations, reflected in bond breakeven rates, surveys, and commodity prices, is an alarming signal.

Different assets respond differently to different types of inflation. Commodities benefit from cost-push inflation associated with supply shocks of raw materials. Stocks of companies with pricing power are better protected from cost-push inflation. Real estate and infrastructure are traditionally considered as protection against inflation.