Demand-pull inflation is a rise in prices caused when buyers’ interest (aggregate demand) surges above productive capacity (aggregate supply). This drives up the cost of goods and services and reduces purchasing power. Understand how demand-pull inflation works to help maximize your investment strategies.
- Written By Thomas J. Brock, CFA®, CPA
Thomas J. Brock, CFA®, CPA
Thomas Brock, CFA®, CPA, is a financial professional with over 20 years of experience in investments, corporate finance and accounting. He currently oversees the investment operation for a $4 billion super-regional insurance carrier.Read More
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Stephen Kates, CFP®
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- Updated: November 21, 2022
- 6 min read time
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What Is Demand-Pull Inflation?
Demand-pull inflation is associated with a demand shock — when one or more factors drive aggregate demand higher, but aggregate supply does not move proportionally. Then, as buyers compete for the limited number of goods and services, the prices are increased.
What Causes Demand-Pull Inflation?
- Strong Economic Conditions
- When an economy is thriving and the rate of unemployment is low, businesses and consumers tend to earn more income and spend more money. This causes aggregate demand to surge. Generally, aggregate supply is not able to keep pace, at least in the short-term.
- Monetary Policy
- This refers to a central bank’s tactics to manage the supply of money in an economy. When a central bank increases the supply of money, it is engaging in monetary easing, which results in more spending. When a central bank decreases the supply of money, it is engaging in monetary tightening, which results in less spending. Significant monetary easing can cause demand-pull inflation.
- Fiscal Policy
- This refers to the utilization of government spending and taxation to influence economic conditions. When a government spends more or decreases taxes, it has a stimulative effect, encouraging spending throughout the economy. Conversely, when a government spends less or increases taxes, it usually has a dampening effect. Highly stimulative programs can cause demand-pull inflation.
- Inflationary Expectations
- Inflation drives expectations for higher future prices, which can lead people to buy more now to avoid higher prices later. Unfortunately, this mentality worsens the situation, pushing present-day prices higher and higher.
"Demand-pull inflation, like any cause for inflation, results in rising prices. From a consumer perspective, this can create an incentive to purchase larger-ticket items soon to avoid future higher costs. From an investor perspective, it can create the incentive to purchase assets now to capture future higher values. Balancing the needs in your life for consuming vs. investing is important to maintain a healthy financial condition."
How Is Inflation Measured?
Inflation is measured by monitoring changes in a price index, which is a basket of goods and services that represents all goods and services utilized within an economy.
- Consumer Price Index (CPI)
- The most renowned index in the nation, the CPI reflects a weighted average of the prices of a basket of essential goods and services commonly used by urban households.
- Personal Consumption Expenditures (PCE) Index
- The preferred inflationary gauge of the U.S. Federal Reserve, the PCE index reflects the weighted average of a broad set of goods and services consumed by all households and non-profit institutions serving those households.
- Producer Price Index (PPI)
- The PPI measures the selling prices received by domestic producers for their output. It measures inflation from the perspective of the seller, which contrasts from the consumer-oriented CPI and PCE index.
The formula used to compute inflation is illustrated below, using the CPI for illustrative purposes.
Demand-Pull Inflation vs. Cost-Push Inflation
Cost-push inflation differs from demand-pull inflation because cost-push inflation is a result of supply-side conditions, not demand-side developments. It occurs when the costs associated with delivering products or services increase broadly throughout an economy, but demand remains firm.
This can be attributed to many things, but the most common drivers are a shortage of materials, geopolitical shocks (such as war, acts of terrorism and sudden trade barriers) and regulatory constraints.
Historical Demand-Pull Inflation Examples
There have been many examples of demand-pull inflation throughout history. It’s important to be aware of them because it can help you recognize when the economy is reaching a similar climate. Then, if feasible, you can modify your spending habits and investment strategies, accordingly.
Real Estate and the Great Recession
The Great Recession of 2007 to 2009 is largely attributable to the massive housing bubble in U.S. real estate prices. The bubble formed because of significant demand-pull inflation in the preceding years. Several factors fueled the situation, including widespread speculative home buying, predatory lending and excessive risk-taking by global financial institutions.
When real estate prices collapsed in late 2007, it resulted in the worst U.S. economic downturn since the Great Depression. The recession quickly spread worldwide, prompting unprecedented fiscal, monetary and regulatory policy that was maintained for the following decade.
In March 2020, the global economy shut down due to the coronavirus pandemic. This immediately decreased demand and froze supply chains worldwide. However, by late 2020, vaccines were introduced, which spurred a global economic recovery that advanced at a rapid speed.
In 2021, as people began to resume normal lives, the demand for some goods and services surged, including gasoline, auto parts, clothing, airline tickets, hotel rooms, catering and entertainment services. The soaring demand quickly overshadowed productive capacity, which had been diminished by the COVID-19 supply chain disruptions.
Notable demand-pull inflation occurred, and it was worsened by a range of aggressive monetary and fiscal policies implemented to stabilize financial markets and support consumers and small businesses.
Should You Invest During Demand-Pull Inflation?
The most effective way to invest during high inflation is to favor assets that have a high probability of generating high income or experiencing value increases in the face of rising prices. This doesn’t mean you should put all your money into these assets. Instead, you could consider the following strategies.
- Reduce fixed-income holdings and value-oriented stocks in favor of large-cap, growth stocks. The potential for high return and the pricing power of these types of companies can bolster the long-term value of your portfolio.
- Establish modest allocations to gold or real estate in your portfolio. These are time-tested inflation hedges that can meaningfully enhance the efficiency (return per unit of risk) of your portfolio.
- Invest in U.S. Series I savings bonds, which are high-quality debt instruments indexed to the CPI. Interest rates float depending on the current level of inflation and are reset every six months.
Battling inflation should never be the central focus of your portfolio. Always strive to maintain a holistic view of your investment objectives, which should reflect your time horizon. Don’t lose sight of your need for capital preservation, income generation, growth and liquidity. If you haven’t assessed these requirements or need some help doing so, consider consulting with a fiduciary financial advisor.
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5 Cited Research Articles
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- Statista. (2022, September 1). Inflation in the U.S. - Statistics and Facts. Retrieved from https://www.statista.com/topics/774/inflation/
- The Federal Reserve System. (2022). About the Fed. Retrieved from https://www.federalreserve.gov/aboutthefed.htm
- U.S. Bureau of Economic Analysis. (2022). Personal Consumption Expenditures Price Index. Retrieved from https://www.bea.gov/data/personal-consumption-expenditures-price-index
- U.S. Bureau of Labor Statistics. (2022). Consumer Price Index. Retrieved from https://www.bls.gov/cpi/
- U.S. Bureau of Labor Statistics. (2022). Producer Price Index. Retrieved from https://www.bls.gov/ppi/