Cost Push Inflation

• Cost-push inflation occurs when the overall prices of goods and services rise in the economy due to a rise in the cost of production. ‘
• Production costs may increase due to factors like a rise in labour costs, raw material prices, supply chain disruptions, or government policy revisions.
• Investing in inflation-beating investments like stocks, IIBs, gold, and real estate can help investors protect their investments against devaluation due to inflation.

Cost-push inflation occurs when the overall prices in the economy increase due to an increase in production costs. In other words, cost-push inflation is caused by the rise in the cost of various production inputs like wages, labour, and raw materials. Producers incur higher expenses when input costs rise. The increased production cost is passed onto consumers by raising the prices of goods and services to maintain steady profit margins. In a nutshell, cost-push inflation happens when the rise in the cost of production inputs lowers the aggregate supply of goods and services in the economy, with demand remaining constant. 

As mentioned earlier, cost-push inflation is caused by a rise in production costs. If the production costs of a company rise, the management will try to pass off the increased amount to the end consumer to maintain its profit margins. As a result, there will be a corresponding rise in the price of the commodity or service in question. If the company does not raise product prices, increased production costs will result in lower profits.

There can be different causes of cost-push inflation, including a rise in the cost of labour and an increase in the price of raw materials. An increase in the cost of these production inputs means higher business expenses for the company.  In other words, the company has to spend more to meet the current demand levels. Producers have to increase the prices of goods and services to compensate for the same and ensure unchanged profit margins. It is important to note that for cost-push inflation to occur, demand for the product must remain unchanged.

Now that you know the meaning of cost-push inflation, it's time to discuss its causes. As mentioned earlier, cost-push inflation is caused by a rise in the cost of inputs used in the manufacturing process.

Increased labour costs

Production of goods requires labour. The rising cost of labour, specifically wages, can result in a cost-push inflation. For instance, labour unions may negotiate higher wages for workers, or the government may increase the minimum living wage limit per worker. In such cases, the company raises the price of commodities to cover the increased production costs.

Rise in raw material prices

Businesses use a range of raw materials to produce various end products. A rise in the price of such materials raises the production cost for companies, forcing a price rise. For instance, if a company uses copper as a raw material and the price of copper rises, it may have to increase the prices of its end products to ensure unchanged profit margins.

Rise in taxes

If the government increases taxes levied on the business, the overall cost of production rises. Businesses may decide to pass the additional tax burden to the customer by raising the price of their goods and services.

Supply chain disruptions

Cost-push inflation may be caused by sudden supply chain disruptions like shortage of raw materials or transportation issues. Factors like conflict, natural disasters, and sanctions can also result in supply chain disruptions. For instance, a sudden natural disaster like an earthquake or flood can partially or entirely disrupt the supply chain.

Changes in government policies

Revisions in government policies can sometimes cause cost-push inflation. For instance, if the government mandates the provision of health care benefits to workers, the cost of labour will automatically rise. This will be tackled with a corresponding rise in the prices of goods and services.

Cost-push and demand-pull inflation are two sides of the same coin. Cost-push inflation happens when there is a rise in prices of goods and services due to rising prices of production inputs. Alternatively, demand-pull inflation happens when the aggregate demand for goods and services outpaces their aggregate supply in the economy. In a nutshell, cost-push inflation is caused by a rise in supply costs, while demand-pull inflation is caused by an excessive rise in customer demand. Cost-push inflation is generally associated with a decreased economic output or growth since businesses may reduce production due to rising costs. Demand-pull inflation, on the other hand, is typically associated with economic expansion, resulting in increased economic activity. 

Let’s take an example to better understand what cost-push inflation is. The OPEC, or Organisation of the Petroleum Exporting Countries, is an intergovernmental organisation of the largest oil-producing and exporting countries in the world. In 1973, OPEC restricted oil production, causing oil prices to skyrocket by 400%. As a result, industries like transportation and manufacturing that relied on oil as a raw material were forced to raise prices to cover higher production expenses. In other words, the common man had to pay more for transportation and petrol to manage the rise in crude oil prices. 

Regardless of the causes of cost-push inflation, its effects on the economy and the individual remain the same. Here’s a quick run-down of the effects of cost-push inflation:

Lowered purchasing power

Cost-push inflation lowers the value of money, reducing the purchasing power of consumers. In other words, it lowers the real income of consumers since more money is needed to purchase the same goods and services.

Possibility of rising unemployment

Rising production costs may force companies to make production cuts, which may include retrenchment of workers. If cost-push inflation is caused by rising wages, the companies may decide to automate processes to lower costs, resulting in rising unemployment levels.

Wage-price spiral

Workers may demand higher wages to manage the increased cost of living due to cost-push inflation. A wage rise leads to a wage-price spiral where increased wages result in higher demand for goods, pushing commodity prices higher. As prices rise, workers demand higher wages, and the inflation spiral continues.

Diminished economic growth

Overall, cost-push inflation causes stagnation in economic activity since businesses are faced with higher production costs.

Economists use different indicators to measure the inflation levels of an economy. Let’s review the common indicators of inflation:

Consumer price index (CPI)

CPI is the most common economic metric used to measure inflation. The consumer price index measures the average change in the prices of a basket of goods and services purchased by households over a period of time.

Producer price index (PPI)

The producer price index measures the average change in selling prices domestic producers receive for their goods and services over time.

GDP deflator

GDP deflator is a measure of the changes in the overall price levels of all domestically manufactured goods and services in the country within a period of one year. It measures the inflationary pressures across the entire economy.

As mentioned earlier, cost-push inflation has the power to erode the purchasing power of your funds. Therefore, most investors seek inflation-beating investments to protect their wealth against possible devaluation. Here’s a list of inflation-beating investments you can consider:

Stocks

You can consider investing in shares of companies that have offered inflation-beating returns historically. Suppose the stock offers an annualised return rate of 10% while the inflation rate remains around 5%. In this case, your returns are still double the rate of inflation. Investing in defensive stocks of consumer staples is prudent because the demand for these essential commodities remains more or less consistent even during inflation.

Inflation-indexed bonds

If you are a low to moderate-risk investor, you can consider inflation-indexed bonds or IIBs. Issued by the Indian government, these bonds offer inflation-adjusted returns to protect your investment against devaluation.

Real estate

Property value and rental income tend to rise during inflation. Therefore, adding real estate to your portfolio will be a prudent choice. Depending on your preference, you can invest in properties directly or invest through REITs.

Commodities

You can also invest in various commodities like gold, other precious metals, and energy products to hedge against inflation. Commodity prices typically rise with rising inflation levels, helping investors minimise the negative impact of inflation on their portfolios.

Hailed as a safe haven asset, gold has acted as a proven hedge against inflationary pressures. As a store of value, gold protects your purchasing power during inflation. With this yellow metal’s inherently limited supply and intrinsic value, gold can protect your wealth against devaluation during inflation. Apart from physical gold, you can invest in gold ETFs and mutual funds to add an inflationary hedge to your portfolio. You can also consider tax-free Sovereign Gold Bonds issued against grams of gold by the GOI. The returns on these bonds are based on the market value of gold. 

Cost-push inflation means the rise in the prices of goods and services as a result of rising input costs in production. Various factors like rising labour costs, raw material expenses, tax burdens, supply chain disruptions, and changes in government policies can trigger cost-push inflation. As an investor, understanding the impact of cost-push inflation is essential for you to plan out your investment journey. Since inflation diminishes the purchasing power of money, parking your hard-earned funds in inflation-beating investments is crucial. Investing in options like stocks, gold, inflation-indexed bonds, real estate, and commodities can help you preserve the value of your funds against inflationary pressures.