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Analysis | Why inflation is heating up and is so hard to cool down

Remark

One of the biggest challenges facing the post-pandemic world is how to contain inflation. After governments spent freely to offset the economic fallout from the Covid-19 pandemic, prices began to rise at their fastest pace in decades and central banks embarked on the most aggressive and synchronized tightening of monetary policy in 40 years. When prices rise, people can afford less, companies struggle to control costs, and in extreme cases, political revolutions ensue.

1. How is inflation measured?

At its most basic level, inflation is an increase in overall prices in an economy over a period of time – usually monthly or annually – and an associated decrease in purchasing power. A common way to measure this is to track the change in the cost of a basket of goods purchased by a typical household, including food, housing and basic services. Leading economists polled by the World Economic Forum in September warned that current rising prices are likely to spark social unrest in low-income countries. The French Revolution was partly caused by the rising price of bread.

2. Is inflation always a bad thing?

No. In a growing economy, some inflation is to be expected as wages rise and demand for goods and services increases. (A general fall in prices, or deflation, is a sign of a weak economy.) The main problem is the rate of inflation. If the rate of price growth exceeds that of wages, the purchasing power of the average person decreases and households and the wider economy suffer. The Federal Reserve Bank of Dallas found that from mid-2021 to mid-2022, U.S. workers experienced the biggest drop in real wages in about 25 years — about 8.5%, including inflation. Independent central banks consider it their main mission to control inflation. They set interest rates and use other policy tools to try to keep inflation at levels considered healthy. In much of the developed world, including the US and the European Union, that ideal percentage is seen as 2%.

3. What drives inflation?

Broad inflationary pressures can come from three channels: supply, demand and expectations. Disruptions in the supply of goods and services have a direct impact on their prices. Pressure on the demand side can arise when the government increases the supply of money by spending more or taxing less, or when the central bank lowers interest rates. If demand exceeds the economy’s productive capacity, inflation is the likely result. As for expectations, the big concern among central bankers is that once inflation becomes entrenched, it will reinforce itself. That’s what happened in the US in the 1970s and early 1980s, until the Fed led by Paul Volcker raised interest rates by as much as 20%, leading to two recessions, and finally pushing prices lower.

4. What caused inflation this time?

There was a supply shock in the early days of the pandemic as Chinese factories closed, the transportation of goods slowed and manufacturers found themselves missing key parts. In many cases, higher costs were passed on to consumers. The post-pandemic recovery increased demand for energy, which in Europe coincided with lower wind turbine yields and a shortage of natural gas. As a result, electricity prices more than tripled in the second half of 2021. There was a second supply shock after Russia, facing sanctions following its invasion of Ukraine, restricted natural gas exports to Europe. On the demand side, pandemic relief programs have pumped trillions of dollars into economies in many countries.

5. How do inflation expectations become self-reinforcing?

If entrepreneurs expect inflation to remain higher than normal, they raise prices. Faced with higher prices, workers demand higher wages. That fuels further inflation. In extreme cases, it can lead to what is known as a wage-price spiral, in which higher wages and higher costs become a loop separate from what is happening in the larger economy. That is considered unlikely this time around, as inflation is driven by food and energy prices, not labor costs.

6. How do central banks combat inflation?

The main way central banks deal with inflation is by raising the interest rates at which banks lend to each other. The idea is that when borrowing becomes more expensive for banks, they pass that on to businesses and consumers, who will borrow and spend less, cooling the economy. But interest rates are often referred to as a blunt tool, meaning it’s hard to use them with precision against whatever is troubling the economy. Raising interest rates can reduce inflation, but it also weakens overall economic growth, and there is always the risk of overshooting.

More stories like this are available at bloomberg.com

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