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Home Finance A Conversation on Inflation

A Conversation on Inflation

by uma

Inflation: Good or Bad?

By Andrea Sismonda: Enterprise Account Manager at Riskified

Mainstream economic theories describe moderate levels of inflation as both the product and the sign of a healthy economy. To test the robustness of this idea, we can start by checking the alternatives.

While zero-inflation economies have theoretical merits, in practice they have severe limitations. Price increases and decreases benefit either debtors or creditors respectively, and to prevent such changes a zero-inflation economy would need to remain completely static. Rather than the compensatory and self-correcting mechanisms in place in inflation-based economies, choices would have to be made following any change in productivity about how to share the burden. The same questions about justice and fairness that we face now would follow. And, anyway, making the transition to such an economy would be a process that only yields its theoretical rewards after a few years of misery.

Even worse, there is little appetite for negative inflation and the possibility of recessions and depressions that could follow it.

A moderate level of inflation, under which an economy is growing, wages are increasing, and people and businesses can plan for the future, seems the healthiest of all possibilities.

Whether then inflation is a ‘good’ or a ‘bad’ thing depends on the rate of inflation, and how robust our ability to control it is. As the rate of inflation rises, so does anxiety and the possibility of an economic crisis. That’s because we may deep down be aware of a dash of Icarian hubris in the faith we place in our ability to control inflation, given its susceptibility to natural disasters and other factors beyond our control. For example, hindsight allows us to see that the twentieth century was plagued by inflation-based disasters, to the extent that it isn’t unusual to hear it called the century of inflation.

And the UK is currently facing a wave of uncertainty so alarming, that even the governor of the Bank of England has conceded the institution’s inability to control it by simply raising interest rates. A PwC analysis in September 2022 predicted that the rate of inflation could pass 20% if the UK government did not act to control energy bills.

Yet, generally speaking and given the lack of plausible alternatives, an economy operating with low or moderate levels of inflation remains the best of all options, and provides the most overall benefit. Of course, economies are not all the same, and understanding how inflation works and what causes it allows one to have a more informed read of the latest news, and a more grounded assessment of the action of the central banks.

What Creates Inflation?

Broadly, we define two main types of inflation. Both occur in cases where supply fails to meet demand, hence market equilibrium is ruptured.

Supply-Driven Inflation

Supply shortages are very often temporary and short-lived. Some residents of the UK comically believed they were facing a national crisis in 2018, when supply chain issues meant KFC were forced to close some outlets and reduce their menus. In that case, things returned to normal once KFC’s supply chain had time to adjust.

But over longer periods, shortages can drive the prices of goods up.

Economies across the world felt the serious effects that supply shortages can have when the cost of an oil barrel quadrupled during the 1979 OPEC oil embargo. An unexpected drop in the availability of a commodity that pretty much every aspect of modern economies relies upon—it’s difficult to think of a sector or industry unaffected by increases in the costs of transport, energy, and plastic production—pushed inflation to almost 7% as the increased cost of oil was passed on to consumers. The legacy of the embargo is still felt today, as international diplomacy, and energy and trade and economic policies, adapted to try and reduce vulnerability to such crises in the future.

More recently, the COVID-19 pandemic provided another fast-track education in the effects of unexpected drops in supply. The automobile industry is still attempting to catch up with a shortage of semiconductors sparked by manufacturing shutdowns and a decrease in production due to erroneous anticipation of a fall in demand. European Central Bank analysis showed a roughly 0.5% increase in the price of new cars in Germany between January 2020 and April 2021, and as of July 2022 European car production was over 300,00 units short of projections. Similarly, a current shortage of plastic resin owing both to pandemic fallout and extreme weather events around the globe has forced manufacturers to raise prices by as much as 30%, and a looming coffee shortage has pushed the price of certain brands up by 19%.

Central banks fear price rises like these, and want shortages dealt with as quickly as possible. That’s because, unmanaged, shortages can spark a chain of events that sends an economy into freefall. If prices are increasing, or people expect them to keep increasing, workers might demand increases in wages to cover the increased cost of living. Increased wage bills are then passed on to consumers, resulting in higher prices again, which might lead to further demands for increases in wages. To prevent the wage-price inflation spiral taking hold, and to rebalance supply and demand, central banks typically act to stifle demand, rather than allowing price increases to be [remedied] by increases in wages. In cases where price rises are likely to be significant and sustained, raising interest rates can deter spending while shortages are addressed and prices return to their pre-crisis levels.

Demand-Driven Inflation

But the more common cause of inflation happens in the opposite direction. While the previous example could be conceived of as a ‘bottom-up’ process, with increased costs of raw materials bubbling up to consumers, here consumers themselves are responsible, albeit often unwittingly, for increases in prices by forcing demand higher and sometimes faster than supply is able to adjust to.

This can happen for a variety of reasons, but it tends to occur on a more sustained and widespread scale when people either have, or expect to have, more money. The supply-demand curve dictates that when demand increases but supply does not rise to compensate, the result is an increase in equilibrium price. This happened recently, when during the COVID-19 pandemic demand for food, PPE, and home-working products rose so rapidly and to such an extent that suppliers were unable to keep up. Evidence shows that demand for technology to facilitate working and schooling from home rose so sharply during the initial months of the pandemic that the cost of a basket of 34 standard home office products was 17% higher in August 2020 than it had been in March of the same year.

Due to the fact that disposable income increases, and therefore demand-driven inflation, tend to be economy-wide, they can be more dangerous. Compare that with supply-driven inflation, which can feasibly be limited to just one industry, sector, or product.

However, even demand-driven inflation can be tackled with a single weapon. By raising interest rates, spending is disincentivized, thereby lowering demand. The most interest-sensitive sectors of the economy tend to be some of the largest one, such as construction, and therefore a change in interest rates can have effects that ripple throughout the economy. And this comes without the additional complication of needing to wait for supply shortages to be resolved, which can be outside of a central bank’s control.

Who manages inflation?

In the UK, the Bank of England uses data from the Office of National Statistics to gauge how much prices are rising. Since it gained independence from the government in 1998, it has had the power to attempt to control inflation. The European Central Bank has similar responsibilities for 19 European Union countries, as does the Federal Reserve System in the US, and the Bank of Japan in Japan.

Changes to the base rate are so economically consequential because they determine the cost of borrowing for most of the largest purchases and investments. Variable-rate loan, mortgage, and credit card repayments all rise when the base rate is increased, so changes to it have significant effects on household incomes. When The Bank of England increased interest rates to 5.75% in July 2007, it was hoped that deterring spending might help to mitigate the effects of what was then a record-high inflation rate of 3.1% amid rising consumer spending and the relative stability of the early 2000s. The power interest rates hold can be gleaned in the urgency with which that decision was reversed the following year, as it became apparent that GDP had dropped by 0.5% in Q3 of 2008. A shock reduction of 1.5% in the base rate was then initiated to try and restore consumer confidence.

When interest rates increase, consumer demand decreases, savings earn more interest, and home prices decrease. These trends, though not quite all-powerful tools in the pursuit of controlling inflation rates, can help to cool prices down, and therefore exercise a degree of influence over overheating economies. There are still the external factors outlined previously in this article, such as supply-chain disruptions due to natural disasters, to consider, which are beyond the control of central banks.

Why 2%?

The 2% goal has been part of economic doctrine since the 1990s. While there is a variety of opinions on what an ‘ideal’ rate is, and the scientific basis for the 2% figure isn’t as solid as one would hope, it marks a kind of reasonable compromise that signals that an economy is growing at a healthy rate, without edging too close either to deflation or to the high range where prices start to run out of control.

But this is far from the consensus. Japan has been plagued by persistently low inflation rates for decades, and while many publications on the topic attempt to diagnose and propose solutions, there is anecdotal evidence to suggest that any rate above 0% may be all that is necessary to ensure economic stability. Japan has, after all, consistently seen price increases of between 1 and 3 percentage points lower than its Western counterparts, and it has responded with shrugs to some of the pressures currently affecting foreign economies. After reaching 1.75% in 1997, Japan’s inflation rate fluctuated between 1% and -1% before topping 1% again during the 2008 financial crisis. But for a sharp increase following a rise in sales tax in 2014, the rate has continued this trend of hovering about 0%.

Significant cultural differences account for the willingness of Japanese workers to absorb the hit of global pressures through cuts to real wages rather than chasing fluctuating costs of goods. But here is a reminder that there is more than one way to organise an economy. Living standards have fallen during Japan’s so-called ‘lost’ decades of economic stagnation, but inequality has widened and wealth has become more concentrated in countries with supposedly more advanced economies.

Conversely, some adrenaline-prone economists advocate a 4% inflation rate as the target, arguing that it allows more leeway in cases where interest rates need to be lowered to help stimulate an economy. If a central bank reduces interest rates to their zero-bound value (the lowest value interest rates can be lowered to, which isn’t necessarily always precisely 0%) and economic activity still doesn’t show signs of increasing, a liquidity trap can ensue. Consumers and businesses become hesitant to invest due to the expectation that interest rates will inevitably rise again in the future, yet the central bank may find itself without its most powerful tool to help promote spending, or it may need to risk the limited-history policy of negative interest rates. This phenomenon, much like the wage-price spiral, is self-fuelling and can be difficult to escape from. A higher target rate of inflation means instead higher long-run interest rate levels, and therefore more room to lower them to help encourage spending when needed.

Whatever the case, there are challenges ahead for institutions working to control inflation. Current analysis suggests that the Bank of England may need to set rates as high as 6% to combat the UK’s rising cost of living, and the Bank published its own report in October 2022 outlining the possible macroeconomic implications of the climate crisis and the drive towards net-zero emissions by 2050. The combination of independent but equally calamitous crises, in the form of a global pandemic, a war in Europe, and a changing climate, means that these are truly uncharted waters for central banks.

Economics is likely to be a staple of headline news for a while to come.