Supply shocks
Inflation caused by something becoming scarce is a different problem from inflation caused by too much spending, and raising interest rates does not grow more wheat.
Prices can rise because buyers have more money to spend, or because the thing being bought has become harder to produce. The two look identical in the inflation data and require opposite responses.
The two shapes
- Demand-pull. Spending exceeds the economy's capacity. Prices rise, output rises, unemployment falls. Everything is hot at once.
- Cost-push. An input becomes scarcer or dearer — energy, food, shipping, a critical component. Prices rise and output falls. The economy gets worse and more expensive simultaneously.
Against demand-pull inflation, raising rates addresses the cause: less spending, lower prices, and output returns to capacity. Against cost-push, raising rates reduces demand in an economy whose supply has already fallen — deepening the contraction to bring prices down. The central bank is choosing between inflation and recession rather than fixing anything.
Looking through
The standard doctrine is to look through a genuine one-off supply shock: the price level rises once, the annual inflation rate spikes and then falls out of the comparison twelve months later, and tightening into it would cause unnecessary damage.
That holds on one condition.
If a shock persists long enough that people start expecting continued inflation, wage demands and price setting adjust, and second-round effects turn a one-off into a process. The judgement a central bank has to make is not whether the shock is temporary — it is whether it will remain temporary in the minds of the people setting prices. See inflation expectations.
Second-round effects
The mechanism: energy costs rise, so transport costs rise, so food costs rise, so workers seek compensation, so labour costs rise, so firms reprice. The original shock has propagated into categories with nothing to do with energy. Watching core measures and services inflation is how policymakers try to detect this early — see the other inflation measures.
Positive supply shocks
The mechanism runs both ways, and the pleasant version gets less attention. A sustained fall in the cost of an important input, a jump in productivity, or a large expansion of the global labour force available for production all push prices down while output rises. Periods of low inflation alongside strong growth are usually supply-side stories, and are frequently misattributed to skilful monetary policy at the time.
Why the distinction matters to an investor
- Cost-push inflation compresses margins for firms without pricing power, and expands them for owners of the scarce input.
- It tends to produce weaker growth and higher rates simultaneously, which is the least favourable combination for most financial assets.
- It makes central bank communication harder to read, because policymakers are balancing two objectives that point in opposite directions.
- Commodity producers and companies with genuine pricing power behave very differently from the rest of the market in these episodes. See commodities.