How to Play Today’s “Demand-Pull” Inflation

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You can drill down and identify several different sorts of inflation, but they all fall within two general categories: demand-pull and cost-push.

Demand-pull inflation is typically tied to wages, with growing incomes spurring greater consumption of goods and services. As consumption grows, supply tightens and prices go up.

This type of inflation is typically seen in economies that are at or near full employment—i.e., the unemployment rate is typically 4 percent or less. As the economy grows there are fewer and fewer workers to fill available jobs; as a result employers compete with higher wages. You can also see demand-pull inflation in areas which are heavily unionized, giving workers the power to push through wage increases even if the business environment might not be ideal.

Demand-pull inflation is sometimes called monetary inflation, because it can also occur when governments aggressively print money, typically to fund deficits. Good examples are the German Weimar Republic in the 1920s and Zimbabwe in more recent history. Unless production increases in tandem with growth in circulation, you end up with price spirals.

Cost-push inflation occurs on the opposite side of the equation, with input prices rising. That increases a producer’s unit cost, most of which gets passed on to end consumers, which in turn reduces buying power.

Cost-push inflation is most often associated with supply shocks, such as in the 1970s when the Organization of Petroleum Exporting Countries radically cut oil production. That pushed energy prices in the US significantly higher and even resulted in shortages, ultimately pushing the US into recession and resulting in stagflation.

It’s important to differentiate between the two basic types of infl! ation because the policy approaches to combating each are different.

To combat demand-pull inflation, policy makers essentially have to discourage spending while not necessarily reducing employment levels. That is typically achieved through higher taxes which directly drain purchasing power from an economy or raising interest rates to encourage saving.

Unfortunately, cost-push inflation typically can’t be attacked head-on. Since it is usually the result of a shortage of some key commodity, the only direct approach would be to somehow boost production. However, in most countries that lack command economies, governments don’t have the tools to achieve that policy in a timely manner.

Thankfully, though, cost-push inflation typically runs itself out as higher input prices dent economic growth, which ultimately slackens demand. That’s cold comfort in the meantime but, more often than not, governments do best by doing nothing at all.

The US is currently experiencing a bit of both types of inflation, though demand-pull is the more dominant.

While it’s true that the 7.3 percent unemployment rate in the US is still relatively high by historical standards, it has been declining for the better part of three years. Wages have also been relatively stable, even though they aren’t keeping pace with inflation.

Add in slow but steady economic growth and you have a recipe for higher prices driven by growing demand, helped along by increased global competition for resources and money printing by central banks the world over.

And as the global economy continues to improve, the effect will only become more pronounced.

Even as the US government shutdown acted as a drag on the country’s economic growth and dented consumer sentiment, resource producers have been some of the best performing stocks over the past three months.

While the Dow Jones Industrial Average is essentially flat over that period and the S&P 500 has gained ! just 3.1 ! percent, SPDR S&P Metals and Mining ETF (NYSE: XME) is up by 10.7 percent.

Tracking a basket of US-based companies that produce aluminum, coal, copper and steel just to name a few, the exchange-traded fund’s components have been enjoying stable to growing demand of late. After the rout the sector has taken over the past two years, producers have finally rationalized their output to levels where stable prices can be maintained.

They’ve also drastically cut costs in recent years, improving their overall margins, and according to research from Macquarie costs are likely to continue falling from here.

So while inflation is still relatively muted following the global recession a few years back, the pressure is building to the point where attractive entry points are developing.

SPDR S&P Metals and Mining TF rates a buy up to 46, as demand-pull inflation heats up.