Ever wondered how your grandparents bought a house with what would barely be enough to buy a used car today?
Yes, the prices for things are constantly going up, and the main reason is inflation.
Here's a fun fact for you. If you had bought a pint of milk in the UK, in 1960, it would have cost you three pence. Today that will cost you 50 Pence. Can we even buy anything with three pence today? Probably not.
So why does this economic phenomenon happen? And is it a good or a bad thing? Inflation is the rate of increase in the price of goods and services over a period of time.
Traditional economics would dictate that there are two main causes for inflation.
1. Cost-push inflation.
2. Demand-pull inflation.
Cost-push inflation happens when business expenses increase, and these extra costs are passed on to their customers. So with cost push inflation, what happens is that the price of your inputs or your raw materials goes up over time, and that could be because of anticipated events or unanticipated events, like say a natural disaster.
A good example of that would be say what has happened to many of the world's economies coming out of lockdown. On the back of that, we've seen a lot of supply chain bottlenecks, we've seen a rise in shipping costs, we've seen in certain areas a labor shortage, and because of those, the most of those inputs will go into the price of manufacturing, inevitably that has led to higher costs.
Demand-pull inflation which is when the demand for goods and services outpaces supply. This tends to happen when the economy is strong. Demand-pull is probably a better reflection of what happens when the economy is very close to full capacity. In the case of a very well-functioning economy, people may feel that they have more disposable income to spend, and therefore demand for goods and services may go up. And if companies are operating at full capacity, they won't be able to increase their production to keep up with that demand. So that could also be inflationary.
Some economists also see increasing money supply as another major cause of inflation. Around the 70s, a new type of view came to the forefront. And that was posited by famous economist Milton Friedman, and his view, and he actually said this, is that inflation, primarily, and everywhere is a monetary phenomenon.
Milton Friedman is saying, well, this is actually the domain of central banks, and if you look at the response to the great financial crisis, to the pandemic, what central banks have done globally, at least advanced economies, has contributed to an increase in the amount of money supply that's available. And so many of the people who believe in the Milton Friedman monetary theory of inflation, suspect that because there has been such an expansion of money supply, eventually that is going to be extremely inflationary.
But we're not seeing it. And so the question is why? So let me give you an example.
If I walked in to a room, let's say with a bag of cash, and I just put it on the floor, but no one picks it up, and no one did anything with it, its impact on inflation would be nil, because it's just sitting there.
What if we told everyone that there's a bag of cash sitting on the floor, waiting to be picked up, you'd probably get a stampede of people taking the bills out, going down to Costa buying coffees, buying croissants and spending on goods and services.
That situation, the pile of cash that I brought into the room actually is inflationary, because it's leading to more transactions. So the missing link right now is the number, what we call the velocity of transactions, has actually dropped quite a lot.
In order for this money supply to be inflationary, you need to see the transaction levels or that velocity of money go up again.
Consumer Price Index
The most widely used measure of inflation is an economic indicator called the Consumer Price Index. It's calculated by measuring the percentage change in the price of a basket of selected goods and services a typical household uses over a period of time.
This so-called basket can include the price of goods such as food, cars, furniture, and apparel, as well as the price of services such as rent, medical costs and recreational spending.
This is the way inflation is measured across many countries. Each country constructs their own CPI basket, so what is in it is a function of that country's policymakers.
Essentially, what you want to have is a basket that just reflects people's spending habits, monthly spending habits. And so what you put in it is supposed to be a reflection of what a consumer would typically spend on a month-to-month basis.
Economists then take the cost of this basket, divide it by the cost of basket from the year or quarter they're comparing it to, then multiply it by 100. This formula calculates the inflation rate we see in headlines.
This is known as headline inflation, but many argue that something called core inflation is the more valuable metric to follow.
What economists try to do is try to smooth out and remove any of the subcomponents that would be extremely volatile on a month-to-month basis or have no ultimate reflection on the strength of the economy.
Oil, for example, on any given month, you can have oil moving up and down because of factors that are exogenous to how an economy is operating. So what economists will do is say, "Well, we'll look at the headline number to get a feel for how at an aggregate level price levels are doing."
But then if we want to get an idea for the overall trend of prices, then we're gonna strip out some of those volatile components and that will give us a better measure of how these Inflation numbers are panning out.
Now that we understand what inflation is and why it happens, let’s explore whether it’s something we should worry about.
Inflation, is it a good thing or a bad thing?
Well, economists have come around to the view that a little bit of inflation is good. It’s like Goldilocks, you don’t want it to be too hot and too cold. You want it somewhere in the middle. Usually inflation is a sign of a well-functioning, productive and growing economy. But when you talk about hyperinflation, then we're entering into a completely different stratosphere.
Hyperinflation is when prices spiral out of control, with an inflation rate typically increasing by more than 50% per month. Though many things can trigger hyperinflation, it’s most commonly caused by excessive money supply and a loss of confidence in the economy or monetary system.
Take Brazil for example. From 1980 to 1995, the price level increased by a factor of one trillion, meaning you would have to pay one trillion Reais for something that cost you just one 15 years ago. In the case of the Weimar Republic, in Germany, for example, post-World War One, they were experiencing inflation, average inflation of about 300 percentage points per month. These are numbers that are actually so high, it is difficult to comprehend. At one point, the Riggs bank, the German central bank at the time, actually issued a 100 trillion mark note.
It was extremely, extremely painful for many of the people who witnessed and lived through that time. There are loads of these images from the 20s of little kids using stockpiles of cash as Lego, because cash was worthless.
But inflation doesn’t need to spill over into hyperinflation territory to cause trouble. In the 1970s, many of the world’s developed economies witnessed double digit inflation. But it was how the chair of the U.S.’s central bank handled it that made the history books.
We talked about cost push, one of them was an energy supply shock, you had that around 1973-74 with the oil embargo, and then the Iranian Revolution in 1979. So that led to skyrocketing oil prices. At the same time, you had a couple of other things going on, back in the U.S. President Nixon had pulled the us out of Bretton Woods. He had removed some price controls on certain goods and in the food space. So, all of these things contributed to a slow and steady rise in inflation.
Until, we talk about secondary effects, it led to a wage spiral. So workers started demanding an increase in pay. And at one point, we had inflation reach about 14%. And this was around 1980. And the then Fed chair Paul Volcker came in and said, "Okay, well, inflation is the enemy, we've got to cure this." And the only way you can cure this is by hiking interest rates.
So he kept hiking and hiking hiking, the Fed started this interest rate hiking cycle, at which interest rates in the US reached 20 percentage points. Eventually, they managed to start taming inflation and inflation went down to three percentage points by the mid 80s.
But, it came in a very heavy cost, because you had more than 4 million Americans unemployed at the time. And it was it basically led to an economic recession in the U.S. So that was the trade-off that they had to make, in order to keep inflation team or to bring it back to tame levels, the economy had to go through a very painful adjustment period. And that is a reason why, in these day and age, nobody wants to go back to what happened in the 70s and then the painful tradeoffs that ensued afterwards.
What are the changes we've seen countries make to ensure we don't see a repeat of what we saw in the 70s?
One of the most important developments is that we have institutions now, we have central banks whose primary, or one of the main mandates, is to keep an eye on overall price levels in the system. So many developed market, or many central banks out there, their number one goal is to ensure that inflation doesn't get above a certain level.
The magic number is around 2% for advanced economies' central banks, they'll say somewhere around there because it's not too high so that it will start causing secondary effects, but not too low or close to zero or even negative, that we may be dangerously close to that deflation or disinflationary dynamics also, which central banks want to avoid.
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