The Perplexing Question Of What Drives Inflation

by: Gene Balas, CFA

Inflation is influenced by a complicated mix of variables. Examples include measures of how difficult it is to find qualified workers and the amount of spare production capacity businesses have.

Other variables include financial market conditions, such as the value of the dollar relative to our trading partners.

The dollar, in turn, is influenced by many variables, but two of these include interest rates, which are also related to inflation, and investor confidence.

We can then directly correlate inflation with measures of investor confidence - but cause and effect are often interrelated and may be difficult to disambiguate.


By now, most people know the Federal Reserve is arguably nearing its goal to achieve stable inflation at roughly 2% or so. This is a level that may indicate healthy demand sufficient to absorb available supply – thus stimulating even more hiring and investment. With too much stimulus, though, the economy can overheat. Some of us (myself included) remember the high inflation of the 1970s and the early 1980s that was partly in response to overly-loose monetary policy, and it was difficult to tame.

As such, the Fed is gradually normalizing interest rates to levels that will neither speed nor slow the economy. The question on many investors’ minds is, when might inflation sustainably maintain its level around the Fed’s target, such that the level of interest rates reach their long-run neutral rate?

This brings us to the central question: What drives inflation? Some of the reasons are obvious: having to pay workers significantly more, higher commodity prices, and reaching capacity on existing production facilities, among others. There are, however, a few connections that aren’t so intuitive, so let’s walk through the drivers of inflation in a series of graphs. We’ll start with the easiest connections to make.

Labor costs

Economics textbooks tell us that inflation moves inversely to the unemployment rate, in a relationship known as the Phillips Curve. Lately, however, that relationship hasn’t been tight at all, puzzling many economists. However, to be more precise, the relationship between employment and inflation is more closely correlated to the difficulty employers have in finding workers. In the graph below, we compare the Consumer Price Index (CPI), published by the Bureau of Labor Statistics, and a measure from the National Federation of Independent Businesses (NFIB) titled, “jobs hard to fill” in their monthly survey of small business owners. Here, the correlation is more visible. After all, it’s not about simply finding applicants for a job; it’s finding qualified applicants for a job.

Inflation Correlated to Difficulty in Filling Job Openings

Production capacity

Another measure is how much of available capacity (plants, machines, and equipment, etc.) businesses are utilizing. This measure of capacity utilization also is correlated to inflation: If businesses are already operating at full tilt, they can afford to raise prices when demand exceeds available supply. The graph below compares to the CPI measure from the Bureau of Labor Statistics (BLS) compared to capacity utilization, from the Federal Reserve.

Inflation Correlated to Capacity Utilization

The U.S. Dollar

Now we get to some other factors that influence inflation. Currency exchange rates affect prices in several different ways. Inflation tends to be inversely correlated to the direction of the dollar. When the dollar weakens, inflationary pressures can increase, and vice versa. In the graph below, the dollar index is shown inverted, to illustrate this negative correlation.

CPI Inflation Correlated to U.S. Dollar

Why is this so? One reason is simply that a weaker dollar buys fewer currency units abroad, which means that inflation of imported goods increases when the dollar decreases in value against our trading partners.

The second reason is a follow-on to the reason above: if imports are more expensive, to the extent that U.S. businesses compete with foreign goods or services, U.S. companies are given cover to raise their prices as well, and still remain competitive. For example, if a foreign-made car costs 15% more due to currency movements (or tariffs, for that matter), a U.S. car maker can raise its prices by, say, 14% and still compete on price.

The third reason, however, is less intuitive. Many commodities are priced in U.S. dollars, even for international purchasers. If the dollar is rising, that would make those commodities more expensive for global purchasers, so commodity prices tend to fall in dollar terms to remain at a similar price when measured in other currencies.

Other Influences on the value of the dollar

So, these are three reasons why the U.S. dollar can affect inflation. But what influences the price of the dollar? Currency exchange rates are complicated to determine, as there are many inputs, including interest rates, inflation, purchasing power parity of identical goods and services across countries, and other factors. Often, currency movements are caused by sentiment, perhaps a sense of what might happen in the future rather than what happened in the past.

Interest rates

Let’s look at two factors: interest rates and risk sentiment. Interest rates can influence the value of a currency because it makes investing in a particular region more attractive when returns on investment are higher. And we can see a relationship between interest rates and the U.S. dollar, using both short-term rates set by the Fed (the Fed funds rate) and longer-term rates set by the market; in this case, the U.S. 10-Year Treasury yield, in data from Bloomberg. But this relationship isn’t completely perfect.

Dollar vs. Interest Rates

Investor confidence

Another variable is, interestingly, investor confidence. State Street publishes an index that includes a measurement of institutional investors’ changing allocations among asset classes to determine their level of confidence in riskier assets, such as stocks, versus more conservative assets, such as bonds or cash. We can use this index to see how it corresponds to the U.S. dollar, in data from Bloomberg.

When global investors are more enthused and confident about growth prospects in the U.S., they tend to buy U.S. assets, pushing the dollar higher. And the U.S. dollar index (calculated by Intercontinental Exchange, the operator of several market exchanges globally) does roughly move in tandem with the investor sentiment indicator from State Street.

US Dollar vs. Investor Confidence

Of course, the dollar isn’t the only thing influenced by investor sentiment: Treasury yields are, too. Here, we can see the correlation between the State Street Investor Confidence Index and the 10-year U.S. Treasury yield, in data from Bloomberg. This makes sense: investors who are less confident tend to buy Treasuries, pushing prices up and yields down.

10 Year Treasury Yield vs. Investor Confidence

Putting it all together

So, since investor confidence is correlated to both the dollar and to Treasury yields, and since the dollar and Treasury yields are both, in turn, correlated to inflation, can we directly draw an association between investor confidence and inflation? Yes. In the nearby graph, we can see that investor confidence is directly – and inversely – correlated with inflation, as measured by the CPI. (In this graph below, the State Street Investor Confidence index is presented in its inverse, with a positive value expressed as a negative value.)

So, when investor confidence in U.S. financial assets is high, such as in 2015 (remember that confidence is shown as a negative reading in the nearby graph), inflation tends to be lower, partly because the dollar is higher, among other factors. However, the caveat is that we can’t quite tease out cause and effect. Is confidence higher because inflation is lower, or is it the other way around? We may infer, though, that the two tend to move in similar directions, though having explored the topics above, we know that examining this relationship can be a complicated endeavor.

CPI Is Correlated to Investor Sentiment

Of course, inflation is also determined by the earlier factors we examined, such as employment indicators and the degree of capacity utilization, for example. These are the more “traditional” relationships one might expect. But as we explored here, things just aren’t so simple. So, when investors, analysts and economists are a bit perplexed about why inflation hasn’t moved higher even as the economy has been growing, we can now understand why there is so much to puzzle about.


Source for data and graphics: Bloomberg, the Federal Reserve, Bureau of Labor Statistics, Bureau of Economic Analysis (Department of Commerce), State Street, and Intercontinental Exchange.

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