Inflation: What Causes It?

Inflation
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Since the 2008 financial crisis and the Great Recession, investors and executives have become acclimated to a world with low inflation and interest rates. No more. Inflation started growing dramatically in several regions of the globe in 2021, and the United States saw its worst inflation in decades in 2022.

In October 2022, the International Monetary Fund warned that inflation and central banks’ efforts to fight it by raising interest rates could hurt the whole global economy.This is a great reason to learn what causes inflation and how to stop this slow loss of buying power.

What exactly is inflation?

In 2022, inflation, which is defined as an increase in prices across an economy, will have emerged as one of the greatest risks to global prosperity.
When prices increase abruptly, money doesn’t go as far as it used to, which might lead to requests for raises, which in turn can promote further inflation. When prices grow very rapidly, the fundamental functioning of an economy might fail. During instances of “hyperinflation,” for instance, individuals hurry out to spend their money as soon as they are paid, since every hour they wait results in greater costs.

Because of this, central banks often establish an inflation goal and utilize interest rates to guarantee that prices increase at a specified rate. A little amount of inflation is usually innocuous if it is well anticipated. The Federal Reserve strives for an annual price rise of 2%.

Since the spring of 2021, however, prices in the United States and much of the rest of the globe have risen far faster. High inflation has prompted a number of central banks to begin hiking interest rates, which threatens to hamper global development and might trigger a recession in certain nations in 2023. To understand what central banks are doing and how their actions may impact companies, it is helpful to begin with the fundamentals of inflation and its causes.

Why does inflation occur?

The fundamental cause of inflation is excessive demand compared to supply. Former Fed chairman Ben Bernanke states in his macroeconomics textbook with Andrew Abel: “Inflation happens when the aggregate quantity of goods sought at a given price level increases faster than the aggregate quality of products provided at that price level.”

However, what causes demand to exceed supply? It is helpful to study the three pillars of macroeconomics described by David Moss in his book A Concise Guide to Macroeconomics: What Managers, Executives, and Students Need to Know to see why this may occur. Moss organizes the book in accordance with production (how much an economy generates), money (how much currency individuals have or can readily get), and expectations (what people think will happen next). All three factors contribute to inflation.

Supply shocks: Supply shocks are big problems with an important economic input, like energy, that can sometimes cause inflation. For instance, if a conflict causes a large number of oil fields to cease production, the price of energy would rise. Since energy is a necessary component of almost every other commodity, the price of those goods also increases. This is often known as “cost-push inflation.”

Theoretically, a reduction in a good’s supply should result in a higher price, fewer customers, and a new equilibrium. Things are more tricky in practice. A supply shock may result in a continuous price rise since there are few viable alternatives, and hence the price is continually bid higher. Or it might be due to uncertainties about when or if the supply shock will stop or because the initial price rise alters people’s expectations of future inflation.

The demand side of the equation involves the money supply. Moss demonstrates why an increase in the money supply tends to create inflation. In his book, he adds, “With more money in their wallets and bank accounts, consumers often discover new reasons to purchase items.” However, unless the supply of goods and services has expanded in the meantime, the rising demand for items by customers will merely drive up prices, fueling inflation. Sometimes, economists assert that inflation increases when “too much money chases too few products.” This phenomenon is sometimes known as “demand-pull inflation.”

Milton Friedman popularized the money supply theory of inflation when he said that “money is always and everywhere a reality.” While it is true that an increase in the money supply may lead to inflation, Friedman’s argument was overstated.

In many models of inflation, the source is not a rise in the money supply but rather an increase in the money supply that was unexpected. Intuitively, if everyone understands that demand will rise (because more money is flowing), then supply will rise to meet it. Inflation is caused by an unanticipated rise in demand (or reduction in supply). In a similar fashion, people’s inflation expectations influence the actual inflation rate. As costs of products increase, workers’ purchasing power diminishes. Therefore, if individuals anticipate rising inflation, they will negotiate for higher pay to preserve their level of life. However, if firms anticipate wage inflation, they will increase prices more, resulting in what is known as a “wage-price spiral” that fuels additional inflation. Fortunately, wage-price spirals are uncommon.

Due to the importance of expectations, central banks exert considerable effort to preserve their credibility on inflation and keep inflation expectations “anchored.” That basically means that they want to convince everyone that they will be able to reach their inflation goal, so that people don’t worry about inflation numbers from month to month and just believe that inflation will grow by whatever amount the central bank predicts.

Unemployment and price increases

Remember that the cause of inflation is an imbalance between supply and demand. Another method to consider the same concept is to consider the amount of “slack” in the economy at any given moment. An economy generates goods using the time and intellect of people, machinery and other infrastructure, and natural resources. However, for a variety of reasons, economies do not always produce as much as they could: there are many unemployed employees, idle industries, etc. In the aftermath of the financial crisis of 2008, this high jobless rate occurred in numerous nations. There was a great deal of “slack” in the economy, which means that many economic resources were not being used.

In an economy with enough slack, there is a low danger of demand exceeding supply and, thus, a low risk of inflation. If demand suddenly surged, jobless individuals would be recruited, companies would reopen, and production would grow. When an economy is functioning extremely close to its maximum capacitydiwhen there is very little slackk inflation often occurs. Inflation is thus more prevalent when unemployment is low. When the majority of available employees are employed, they are able to demand higher salaries, which may lead to price increases. And there is insufficient personnel available to meet any additional demand. when there are too many dollars chasing too few products.

Low unemployment is not usually associated with inflation. However, when an economy is operating at or near full capacity, there is a temporary trade-off between low inflation and low unemployment.

How does an increase in interest rates affect inflation?

The use of interest rates by central banks to control demand and inflation.If inflation is strong, the objective for short-term interest rates is to increase. Higher interest rates reduce the attractiveness of borrowing costs for businesses and consumers, which reduces demand for products and investment. Since inflation is created by demand exceeding supply, decreasing demand to bring it in line with supply alleviates the price-inflationary pressures.

Central banks can change interest rates in a number of ways, but in the US, “open market operations” are the most common. The target interest rate is set by the Federal Open Market Committee of the Fed. After that, the Fed buys and sells bonds and other assets to change the amount of money in circulation and the short-term interest rate.

How inflation is accounted for

There are a variety of metrics for measuring inflation, each of which attempts to monitor increases in the prices of a variety of items. The consumer price index, or CPI, is often mentioned. The CPI measures the average price of a sample basket of household-purchased items, weighted by how much households spend on each item. When the CPI increases, it indicates that household costs have increased on average.

Economists often prefer to examine the “core CPI,” which excludes food and energy costs. The reason for this is that the costs of these two categories fluctuate significantly from month to month. By excluding these two categories from the average price level, it is simpler to determine if the economy is experiencing a price rise.

Other indices include the producer price index, which monitors the price firms pay for inputs, and the personal consumption expenditure index, which measures consumer prices using a different methodology.

What is the current cause of inflation, and what will be the reason in 2021 and 2022?
Inflation has been high for the last year and a half because of factors on both the supply and demand sides. On the supply side, there were transportation bottlenecks and labor shortages created by COVID-19, as well as energy and food price hikes prompted by the invasion of Ukraine. Unexpectedly, the cost of energy and transportation increased the price of a variety of commodities, which had a ripple effect on the economy.

During the epidemic, several governments sent significant quantities of money to people and businesses so that they could handle lockdowns and layoffs. This may have led to inflation by increasing the money supply. Demand for tangible things (cough, pelotons, cough) skyrocketed during the epidemic, since customers were unable to spend their money on restaurants and other services.

No one knows with certainty how much each of these things contributed. Economists at the New York Federal Reserve anticipated that supply-side variables would account for 40% of the price increase in 2021, while demand-side factors would account for 60%.

When will inflation decrease?

Again, nobody knows for certain. However, as of this writing, the following predictions hold:

The Federal Reserve anticipates that inflation will reach its peak in 2022 and begin to decline in 2023. However, it does not anticipate inflation returning to its objective of 2% until 2025.

The experts at Morgan Stanley think that global inflation will reach its highest point in the last three months of 2022.

Analysts at Goldman Sachs think that core PCE inflation will drop sharply from about 5% per year to 3% per year in 2023.

How to deal with inflation

The majority of components of effective management are unaffected by inflation. However, managers should consider the following at this time: The first is how to cope with the possibility of price increases. Mark Bergen of the University of Minnesota and his colleagues outlined some potential options in a recent HBR.org article. Ensure that you have a strategy in place for when and how you adjust your rates, and do all possible to reduce the expense of making such changes. These charges, which economists refer to as “menu costs,” may accumulate.

This HBR article by Dartmouth’s Vijay Govindarajan and co-authors also includes suggestions for coping with inflation. One of them is increasing communication with workers and focusing on morale. When the labor market is tight, you may need to do more to keep personnel, which may be challenging owing to increasing interest rates and costs of capital (more on that in a second). In a separate article, Lou Shipley, a professor at Harvard Business School and former CEO of a technology business, advocates prioritizing the workers you need to keep the most and concentrating on your company culture, which is a crucial part of retaining personnel.

That is how to manage the condition, but you must also have a strategy for controlling the cure. In light of the fact that central banks combat inflation by increasing interest rates, businesses must also evaluate their strategies and operations. A rise in interest rates increases the cost of borrowing and shifts investors’ focus to short-term gains.

Informational Resources on Inflation

Why Inflation Is Rising: An Article from Econofact

The CRS overview of inflation in the United States.

Brief Principles of Macroeconomics, by David Moss (HBR Press)

 

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