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By Jason Stipp and Robert Johnson, CFA | 04-10-2013 12:00 PM

The 4 Factors of Inflation

Morningstar's Bob Johnson explains the sources of higher prices, and what they're implying about the potential of future inflation.

Jason Stipp: I’m Jason Stipp for Morningstar. Of all the indicators he watches, inflation is one of the most critical to our director of economic analysis, Bob Johnson. He is here to explain why and to give us a read on what the current inflation indicators are saying.

Bob, thanks for joining me.

Bob Johnson: Great to be here.

Stipp: So, you say that inflation is very important to watch because of its connection to recessions. It's not necessarily a direct connection, but can you explain your thinking on recessions connected to inflation somehow?

Johnson: Absolutely. Inflation is the number-one predictor of recessions, and it's a very timely measure. It doesn't come two years in advance. The time lags between increased inflation and the recession is very close and very similar from recession to recession. There are a lot of indicators that can be relatively good. The Institute for Supply Management Manufacturing Index is once in a while good, but it signals three false readings for every positive reading, so it’s got a lot of volatility. Some of the other measures are also pretty good, but sometimes they lead by two years and some times by two months, and so it doesn't do a lot of good.

Stipp: What's the mechanism that makes this such a timely notice of a potential recession?

Johnson: Yeah. Again there may be, as you alluded to, another cause of the recession, like the big housing bubble this last time around, but really we might have survived a little bit better. But what happened is we had a bout where gasoline prices and food prices went up dramatically, at the same time the housing market was beginning to fall apart. The approximate cause was actually inflation, even though the root cause was the housing situation.

Now, here is the mechanism. What happens is, consumers tend to get their wage increases once a year, if that these days, or their bonuses once a year. So, if inflation runs along at a certain percent and all of a sudden it’s a lot higher, they immediately kind of have to cut back. They have to say, "Well, all right, my gasoline price is up, so I’m going to have to cut back what I’m spending somewhere else." So, they start cutting back on their spending, and then that creates less need for production, and that means you need less employment. If you employ fewer people, that means less income, and that means less spending. And so you get this vicious cycle started. Until prices actually turn around and start to go down, the vicious cycle kind of continues.

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