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Explainer: What is inflation and why does it matter?

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Explainer: What is inflation and why does it matter?

13 Jul 2022 | By Peter Dragicevich

Inflation is an increase in the level of prices of the goods and services that households buy. It is measured as the rate of change of the prices within the consumer price index, i.e., a specific ‘basket’ of goods and services weighted by spending patterns in the economy.

Typically, prices rise over time, but prices can also fall. This is called “deflation” and was the risk central banks were grappling with in the period prior to the COVID-19 pandemic. However, we are now in a different environment, with inflation running at multi-decade highs.

Understanding the drivers of inflation

For policymakers, what is driving inflation ― and the likelihood of its persistence ― matters. That is why understanding the different types of inflation is important.

The main types of inflation are:

  1. Demand-pull inflation. This occurs when activity is strong and demand for goods and services outpaces the ability of an economy to increase its production capacity.
  2. Cost-push inflation. This is the result of a jump in input prices working through the production process. A large lift in oil or a one-off tax hike are examples. Policymakers usually look-through and don’t respond to these external inflation shocks as they aren’t expected to last.
  3. Built-in inflation. This is also known as a wage-price spiral. This occurs when the cost of living rises, and in response, workers demand higher wages. To offset their higher costs businesses then raise their prices, leading to a self-reinforcing loop.

The current environment

There are elements of each of these different inflation types now at work. Since the onset of the COVID-19 pandemic, the mix of strong demand ― on the back of the enormous amount of policy support provided ― and rolling supply disruptions has seen inflation surge.

In addition to promoting ‘full employment’, central banks have a ‘price stability’ mandate which is aimed at controlling the rate of inflation:

  • in Australia, the Reserve Bank targets 2-3 per cent inflation on average over time
  • in the United States, the Federal Reserve targets 2 per cent per annum inflation.

Over the medium-term, price stability ― or a relatively constant level of inflation ― is a fundamental macroeconomic pillar that helps preserves the value of money and should lead to relatively more stable growth as it gives businesses and consumers confidence to plan for the future.

What are the risks for prolonged periods of inflation?

Prolonged high inflation is problematic as it erodes consumers’ purchasing power. This is a particular issue for lower income households as inflation is a ‘regressive tax’. High inflation also distorts spending and investment decisions, and it can lead to a self-fulfilling change in consumer and business price-setting behaviours that can become embedded

Factors to consider in the outlook ahead

After keeping policy settings too loose for too long, global central banks are now reacting to the very high inflation by aggressively raising interest rates. The tightening in policy settings is designed to slow down growth, rebalance demand and supply, and get inflation back down to target.

Over the past few months this abrupt shift in interest rate expectations has generated increased market volatility. The policy normalisation process is only part way done, and the economic impacts are yet to materialise. As such, volatility can continue for a while. The path forward for inflation will be critical for markets.

This is a developing environment, so as always, stay close to your adviser.

 

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