Informed Investor: Inflation ≠ Prices

Inflation is one of those words that has become ubiquitous… it’s everywhere (and has been for years now). It’s a crucial economic indicator to be sure, but you rarely read a single business news story since the pandemic that didn’t mention inflation (or fear of it). So… what exactly is it? Why does it matter? And perhaps more importantly, why the heck are my groceries still so dang expensive if inflation has been falling for months now? 

In this installment of the Informed Investor, we’re going to break down why cooling inflation doesn’t always result in lower prices, what separates inflation from the cost of goods, and how the two might be related (but often don’t move in sync).

Inflation 101: What Is It Really?

First, let’s clarify what we mean by inflation. Inflation is the rate at which the general level of prices for goods and services rises (which in turn reduces the purchasing power of your money). The $20 bill in your wallet is still worth $20… you just can’t buy nearly as much with that $20 as you could 20 years ago (or as it turns out, 2 years ago).

Too much inflation can be pretty dangerous to national economies, so central banks like the Federal Reserve keep a close eye on it to try and maintain a stable economy (mostly by adjusting interest rates, or how expensive it is to borrow money).

Slowing inflation is great news in our current context… but it’s not the whole story. When inflation slows, it doesn’t necessarily mean that prices will drop. That’s because inflation is usually measured in percentages — if the inflation rate drops from 7% to 4%, it means prices are still increasing… just not as quickly as they were before.

The prices of goods have already gone up; they’re still going up, just not as quickly (and they’re not likely to return to pre-inflation levels).

The Cost of Goods: More Than Just Inflation

While inflation influences the overall price level, the cost of specific goods is driven by a variety of factors that often operate independently of inflation. Here are a few key drivers that directly impact the prices of everyday goods:

• Supply Chain Disruptions: From shipping delays to raw material shortages, supply chain issues can cause price spikes. For example, computer chips became scarce during the pandemic, driving up prices for electronics like laptops and smartphones (even though inflation was relatively stable for other categories).
• Labor Costs: As wages rise, companies face higher production costs. If factory workers or truck drivers see wage increases, the businesses they work for may pass those increased costs onto consumers, affecting everything from cars to clothing.
• Energy Prices: Fluctuations in energy costs, such as oil or natural gas, directly affect the cost to produce and transport goods. If fuel prices rise, so does the cost to ship your groceries or heat your home.
• Corporate Pricing Strategies: In some cases, companies raise prices simply because they can. During inflationary periods, consumers may expect prices to increase, allowing companies to raise costs without significant backlash.

Inflation vs. Cost: Why Are They Different?

This brings us to the central question: why doesn’t lower inflation mean lower costs for you?

Inflation reflects the overall change in price levels across a wide array of goods and services, while the cost of individual items can fluctuate independently. The cost of steel, for example, might rise due to supply constraints or tariffs, even if the inflation rate is trending downward. Likewise, the price of a plane ticket may jump due to increased fuel costs or higher demand for travel, despite inflation slowing elsewhere in the economy.

Think of inflation as the general trend and the cost of goods as the specifics. Inflation tells us about the broader economic landscape, but individual costs are influenced by more localized and immediate factors.

What Does This Mean for Your Investments?

Understanding the difference between inflation and the cost of goods is key to making informed investment decisions. Inflation affects interest rates, which in turn can influence your returns on bonds, savings, and even stocks. High inflation often prompts central banks to raise interest rates to cool the economy, which can lead to a slowdown in economic growth.

On the other hand, certain sectors may continue to experience rising costs even when inflation slows. For example, food prices could remain high due to weather disruptions affecting crop yields. Similarly, housing certainly has been hit by inflation, but high home prices in desirable urban areas are impacted far more by decades of constrained housing construction policies. 

Investors should pay attention to companies that can pass their rising costs onto consumers. Businesses with strong pricing power — like healthcare companies or luxury brands — tend to perform better during inflationary periods because they can adjust prices without losing demand. On the other hand, sectors that are heavily reliant on raw materials, like construction or manufacturing, might suffer as those input costs remain elevated (even if/when inflation cools).

Key Takeaways for Investors

Let’s break down a few actionable insights:

• Focus on Sector-Specific Trends: Inflation may not impact every sector equally. It’s crucial to look beyond the general inflation rate and examine specific industries — like tech, agriculture, or real estate — where costs might be influenced by other factors.
• Consider Pricing Power: Consider investing in companies that have the ability to raise prices without losing customers. Brands that dominate their markets or offer essential services, like utilities or healthcare, tend to weather inflationary periods more effectively.
• Stay Diversified: While inflation affects the overall economy, sector-specific factors like energy prices or labor shortages can hit certain industries harder. A well-diversified portfolio helps to cushion the blow from both inflation and sector-specific cost increases.

Yes, inflation is cooling… but that doesn’t mean your eggs are magically going to get cheaper. It’s a useful lesson — understanding the nuances between inflation and the cost of goods can help you be a more Informed Investor.

If you want to hear more about what macroeconomic trends we’re tracking (and what they mean for our investment strategy), drop us a line — we always love to talk shop.

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