Inflation Sensation: A Guide to Understand the Era of Rising Prices

Inflation is one of the most widely used and widely misunderstood concepts in economics. We’ve talked about it in a previous article, but I think it’s a concept that deserves to be revisited. In simple terms, inflation is the general increase in the prices of goods and services over time. It is measured by the percentage change in the price level, such as the consumer price index (CPI) or the producer price index (PPI).

Inflation matters for the economy and society because it affects the value of money and the purchasing power of people. A moderate and stable rate of inflation is generally considered desirable, as it indicates a healthy and growing economy. However, a high and volatile rate of inflation can have negative consequences, such as eroding the real income and wealth of people, distorting the relative prices and incentives of economic agents, and creating uncertainty and instability in the financial markets.

In this article, we will explore some of the key aspects of inflation, such as the difference between headline inflation and underlying inflation, the impact of inflation on the purchasing power of people, and the main reasons behind the recent surge in inflation around the world.

Inflation vs. Underlying Inflation

The price level is influenced by many factors, some of which are temporary or specific to certain sectors or regions. This makes measuring inflation more challenging than it should. For example, the price of oil or food can fluctuate significantly due to changes in supply and demand, weather conditions, geopolitical events, or other shocks. These factors can cause the headline inflation rate, which reflects the overall change in the price level, to deviate from the underlying inflation rate, which reflects the persistent and generalised change in the price level.

The underlying inflation rate, on the other hand, is calculated by excluding the prices of certain goods and services that are subject to high volatility or transitory influences. For example, one common way to measure the underlying inflation rate is to calculate the core inflation rate, which excludes the prices of food and energy, as they are considered more sensitive to external shocks. Another method is to calculate the trimmed mean inflation rate, which excludes the prices of the goods and services that have the largest increases or decreases in a given period. There are many other ways to measure this particular inflation rate, such as the weighted median inflation rate, which takes the price change of the median item in the basket of goods and services, or the common component inflation rate, which uses a statistical technique to extract the common trend among the prices of different items .

The underlying inflation rate is useful for policymakers, businesses, and consumers, as it provides a more accurate and reliable indicator of the inflationary pressures and expectations in the economy. It also helps to assess the appropriate monetary policy stance and the inflation outlook.

How Inflation Affects Purchasing Power

Another important aspect of inflation is how it affects the purchasing power of people, which is the amount of goods and services that a unit of money can buy. Inflation reduces the purchasing power of money, as it means that people need more money to buy the same amount of goods and services as before. Conversely, deflation increases the purchasing power of money, as it means that people need less money to buy the same amount of goods and services as before. As nice as it may sound, experiencing deflation is not good either, as people will tend to keep their money and spend as little as necessary in hopes that prices will decrease over time, which can end up “freezing” the economy and affecting a country’s GDP and production in a negative way.

The impact of inflation on the purchasing power of people can be seen in various aspects of their economic life, such as the costs of living, savings, investment returns, and debt. Inflation can be easily seen in many aspects, such as:

• The costs of living: Inflation increases the costs of living, as it means that people have to spend more money on their basic needs, such as food, housing, transport, health, and education. This can reduce their disposable income and their standard of living, especially for those with low or fixed incomes. To measure the impact of inflation on the costs of living, economists often use the real income, which is the nominal income adjusted for inflation, or the real wage, which is the nominal wage adjusted for inflation.
• Savings: Inflation reduces the value of savings, as it means that the money saved today will be worth less in the future. This can discourage people from saving and encourage them to spend or invest their money. To measure the impact of inflation on savings, economists often use the real interest rate, which is the nominal interest rate minus the inflation rate, or the real return, which is the nominal return minus the inflation rate.
• Investment returns: Inflation affects the returns of different types of investments, such as stocks, bonds, or real estate. Generally, inflation benefits the owners of real assets, such as land, buildings, or commodities, as their prices tend to rise with inflation. However, inflation harms the owners of nominal assets, such as money, bonds, or loans, as their value tends to fall with inflation. To measure the impact of inflation on investment returns, economists often use the real rate of return, which is the nominal rate of return minus the inflation rate, or the real capital gain, which is the nominal capital gain minus the inflation rate.
• Debt: Inflation affects the burden of debt, which is the amount of money that a borrower owes to a lender. Generally, inflation benefits the borrowers and harms the lenders, as it means that the borrowers can repay their debt with money that is worth less than when they borrowed it. The main borrowers in today’s economy are the governments, and they find higher inflation rates desirable given their tendency to incur in deficit on a constant basis.

Main Reasons Behind the Inflation Surge

The recent surge in inflation around the world has been a source of concern and debate among policymakers, businesses, and consumers. Considering that the target inflation of the main central banks (i.e. the Federal Reserve and the European Central Bank) is 2% YoY, the last few years have been catastrophic in that regard. We saw the inflation rate hit 10% YoY in the US, and values even higher than that in several Eurozone countries (Oct 2022) like Slovakia (15.9%), Estonia (14.9%), and Slovenia (14.6%).

What are the main reasons behind this inflation surge? There is no simple or definitive answer to this question, as inflation is a complex and multifaceted phenomenon that can be influenced by many factors, both domestic and global, both supply-side and demand-side, both short-term and long-term. There is, however, one main cause that stands out above the rest, and that is expansive monetary policy.

The COVID-19 pandemic triggered a coordinated response from the monetary and fiscal authorities around the world. In an effort to mitigate the economic and social impact of the pandemic, the central banks adopted ultra-loose and unconventional monetary policies, not just by keeping interest rates low for longer than expected, but also by swarming the economy with money via quantitative easing, and providing liquidity and credit support to the financial system and the real economy. The governments agreed with this point of view, and decided to pass massive and unprecedented fiscal stimulus packages, such as increasing public spending, providing income and wage support, and offering tax relief and subsidies to households and businesses. These policies have resulted in a significant increase in the money supply and the public debt in many countries. What happens when production of goods and services remains stagnant but the system is flooded with new money? Correct: the value of money relative to goods and services can only go down, resulting in massive inflation rates.

This is not easy to translate into everyday economics, but I promise it does affect us. In the last four years, we have seen an unprecedented spike in the money supply of the main central banks. While this can be helpful in the short term, the long-term effects of injecting huge amounts of liquidity into the system can be very detrimental for the economy, causing the inflation rate to remain at unreasonably high levels for a long time. Subsidising inactivity during an exceptional circumstance such as a pandemic may sound acceptable because there were public health reasons involved, but expansive monetary policy goes all the way back to 2008. During the last fifteen years, there have been many businesses and sectors that became reliant on “free money”, and the decisions of the people in charge of the monetary policy (i.e. the central banks) were heavily influenced by the governments, showing a lack of independence and financial responsibility. By supporting fiscal policies that involve public deficit and turning public debt into money, the central banks planted the seed for the inflation we are suffering today.

Chart: Money Supply (M2) in the US and the Eurozone

Notice how both series look very similar. The growth rate increased slightly after 2008, and skyrocketed after 2020, because both parties reached a consensus on the steps that they were going to take. Again, more dollars (or euros) in the market means each dollar (or euro) is worth less and less. This is, in my opinion, the most intuitive way to understand inflation: instead of higher prices, think of it as “my money is less valuable now because more people have it”.

There is another big factor that plays a role in the fluctuations of the inflation rate, and that is the expectation of inflation and the wage-price spiral: The expectation of inflation can create a self-fulfilling prophecy and a vicious cycle. Expectations are often more than enough to drive the markets: if people expect the prices of goods and services to rise in the future, they may demand higher wages and salaries to maintain their purchasing power and standard of living. This can increase the costs of production and the prices of goods and services, which can further fuel the expectation of inflation and the demand for higher wages and salaries. This can create a wage-price spiral, where the inflation rate and the expectation of inflation feed on each other and spiral out of control .

Conclusion

In this article, I have explored some of the key aspects of inflation, such as the difference between headline inflation and underlying inflation, the impact of inflation on the purchasing power of people, and the main reasons behind the recent surge in inflation around the world. While most of it was facts, I have also shared my view on the root cause of inflation, but I don’t want you to just take my word for it. Remember: The Economic Man is open to many sources of knowledge, but tries not to let them shape his opinion on things. After reading this article, you may be interested in reading news articles, economics papers or any other content on inflation. Try to read them by keeping your experience present, and figure out how inflation has affected your life and your decision-making.

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