Understanding the Power of Cost Pull Inflation

Cost pull inflation, otherwise referred to as cost push inflation, is a micro and macroeconomic phenomenon that occurs when the prices of products at the wholesale level increase prices at the retail level, or increases in production prices create higher prices on the end user.

Cost Pull Inflation Explained

One of the best explanations for cost pull inflation rests in the 2008 oil bubble and resulting rising prices at the consumer level.  As the cost of oil rose from $50 to $150 in only a few years, the prices of every product from sugar and cotton to wheat and even electronics rose in tandem.  Why did this happen?  It was the result of cost push inflation.

Oil is used in the production or transportation of virtually every good produced around the world.  Plastics are made with oil by-products.  A table made in Vietnam is transported via ship with the help of a diesel powered engine.  Food grown in Hawaii is shipped by plane all around the world, consuming oil in the process.   This is a perfect example of cost push inflation, where an increase in the price of production elements creates inflation in the price of the end product.

Not Monetary Inflation

It is important to note the difference between monetary and cost pull inflation.  Monetary inflation involves rising amounts of currency circulating around the globe, whereas cost pull or cost push inflation require no changes in the money supply for higher prices.  This is a very important distinction, and one all traders should remember.

Making Money on Cost Pull Inflation

There are only a few ways to profit on inflation.  One of the best ways to trade the effect of cost push inflation is to buy or sell Treasury Inflation Protected Securities, or TIPS.

Unlike other Treasuries issued by the US Treasury Department, TIPS are inflation adjusted.  That is, if you were to purchase a TIPS bond at a yield of 3% and inflation is 4%, you would receive a disbursement equal to 7% of your investment.  You enjoy 4% to cover inflation and 3% as profit.

You can also make money as TIPS rise in price.  Usually, when investors fear rising inflation, whether due to cost pull inflation or monetary inflation, the price of TIPS rises several percentage points as investors bid down the yield.  Those who get in early profit the biggest.

Another popular way to protect against cost push inflation is to short sale companies with excessive exposure to high cost items.  For instance, during the rise in oil prices, traders would have been smart to sell short shipping companies, as their profit margins were squeezed as oil prices headed higher.

Basic economic theory suggests that there are less people willing to pay higher and higher prices for certain goods, so even if cost pull inflation is persistent, it is not certain that a business will find a way to effectively pass on the costs to consumers.

Cost Push Inflation

Recognizing cost push inflation is a very important skill for long term traders.  Often, following a long period of cost push inflation is a long and sustained economic recession and lower stock prices.  If you can see those periods in advance, there are literally billions of dollars to be made!
Tim Ord
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