Not Everything That Goes Up, Must Come Down

When they say inflation is lower, they don't mean prices are down.

Friday, December 1, 2023

The recent surge in the stock market has been driven to some degree because the consumer price inflation rates, by pretty much all measures, is way down from last year's high.

The headline Consumer Price Index (CPI) inflation rate topped out at 9.1% y/y in June 2022. In November of this year, it was down to 3.2%, much closer to the Fed's target rate of 2%, but not quite there. The core rate, which excludes food and energy, eased from a peak rate of 6.6% in September 2022 to 4.0% in November. And there are a bunch of other ways you can slice and dice this further to remove skew from outlying components like used cars and fake ones like owner’s equivalent rent, which no one actually pays. You can do all these things with the Personal Consumption Expenditure (PCE) price index, too. Its headline measure, which is the Fed’s targeted inflation gauge, slowed from 7.0% y/y in June 2022 to 3.0% in October, the latest figure available. These are the main measures economists and the Fed refer to, and they are all down.

When they say that inflation is down, what they are saying is not that prices are falling... but that prices are going up at a slower rate than last year.

On it's face, this seems to be good news. However, along with many others, you may be wondering why prices still seem so high compared to just a few years ago. If inflation is down, wouldn't prices be falling too? Not necessarily. When they say inflation is down, what they are saying is not that prices are falling back to previous levels, but rather that prices are going up at a slower rate. Unfortunately, not everything that goes up must come down!

In economic theory, a decrease in inflation rates is often associated with the expectation of lower prices for goods and services. However, the real-world dynamics of pricing are more intricate than a simple inverse relationship with inflation. Contrary to common expectations, prices do not always follow a downward trajectory when inflation goes down. This phenomenon can be attributed to various factors that influence pricing mechanisms in the market.

Sticky Prices and Contracts: One of the primary reasons prices may not decrease during periods of low inflation is the concept of sticky prices. In many industries, businesses establish contracts and agreements with suppliers, employees, and other stakeholders based on certain price expectations. These agreements may have a lasting impact, causing prices to remain relatively stable even when inflation rates decrease.

Cost Pressures: Businesses face a myriad of costs, including raw materials, labor, and operational expenses. While low inflation might suggest a decrease in overall price levels, businesses may still grapple with cost pressures. If the costs of production, transportation, or other essential inputs do not decrease proportionally, companies may be hesitant to reduce prices to maintain their profit margins.

The real-world dynamics of pricing are more intricate than a simple inverse relationship with inflation.

Market Dynamics and Competition: In some cases, the competitive landscape within a market can influence pricing strategies. Businesses may prioritize maintaining market share or profitability over immediate price reductions. Additionally, industries with low competition may be less inclined to lower prices, as there is less pressure from rivals to do so.

Consumer Expectations: Consumer expectations play a crucial role in pricing dynamics. If consumers do not anticipate lower prices or do not change their purchasing behavior in response to reduced inflation, businesses may have little incentive to lower prices. Perceived value and brand loyalty can also influence consumer willingness to pay a certain price, irrespective of inflation trends.

Psychological Factors: Psychological factors, such as the perception of value and the anchoring effect, can contribute to the inertia in price adjustments. Consumers may be anchored to previous price levels and find it psychologically challenging to accept reductions. Businesses, aware of these consumer behaviors, may hesitate to lower prices for fear of signaling a decrease in product quality.

The relationship between inflation and prices is far from linear. While economic theory suggests that lower inflation should lead to lower prices, real-world market forces and behavioral considerations often defy this expectation. Understanding these nuances is crucial for a comprehensive comprehension of the intricacies of the market and its responses to economic variables. Hope you have a great weekend!

Blessings--

Jim

(The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.)