
If you’ve taken a look through the “Business section” in most newspapers in the past months, the topic of this post should come as no surprise to you: Inflation is on the rise. But, come to think of it, what does inflation really mean?
And why is it bad that it is rising all of the sudden? Also, what will / can the government do to stop this? A couple of these questions are probably going to interest some of you, so let’s begin with…
What is inflation and why does it happen?
Inflation is the decrease of purchasing power of a currency (or for the sake of simplicity, money in general) over a period of time. This means that an amount of money that was once able to purchase something is now worth too little to purchase the same product. In other words: The money that you had, say, 5 years ago buys you less now than it did then. But why does it happen? Inflation generally occurs when either there is a surge in demand for a product or the production costs increase. Most of the time and as we have it now (I’ll get into the current state of things later) the former is the case: Imagine you sold lemonade in winter and business was going badly. You’d want to keep your prices down in order to get any customers at all (or just don’t sell lemonade during winter). Now imagine it’s the peak of summer. People have a longing for an ice-cold glass of your lemonade and demand surges. Amid all the demand you could think to yourself: “If people are willing to pay $1 per cup, I could charge them $1.50”. To illustrate the shortage of goods, imagine there was a shortage of lemons. You’d have to set prices higher in order to make the same amount of money you would’ve made by selling more lemonade. This is basically what’s been happening for a long time in our economy. But why does it spike? And why now?
Before we get to those questions, let’s look at how we even measure inflation. Inflation is measured with the Consumer Price Index or CPI for short. The CPI measures the change in prices of consumer goods & services over time. What are consumer goods & services? Well, think about what you yourself buy and need to live in today’s world: Food, utilities, cars etc. In addition, these goods are weighted based on importance to better reflect how much of what product consumers buy. The CPI rate is usually around 2%. In 2021, it rose to around 5%.
Why is inflation on the rise now?
You may have already guessed the root cause of the rising inflation rate: The Coronavirus pandemic. In 2020 companies dug in for what they thought would be the “second plague”. Luckily, the pandemic didn’t turn out to be nearly as bad and when we realized this, the economy started to reopen in 2021. Unfortunately, a lot of firms now find themselves with hordes of customers that took a break from buying in 2020, now yearning for their products. With production paused for a year (and the economy still being “restricted”), the firms have shortages in materials and thus can’t make products quickly enough to satisfy the customers. This means that the demand has far outgrown the supply in many industries such as cars, air travel and digital devices such as consoles, phones and computers.
Can it get a lot worse?
The short answer is: Maybe. The question for now isn’t if high inflation rates are here to stay, but whether they will get a lot higher. For Inflation to balance out, individual businesses need to see for themselves that it’s time to stop raising prices and even to lower them. This can only happen when people stop buying and people stop buying when they’re out of money. Until Inflation balances out though, some time will pass but whether Inflation will rise a lot more is difficult to say at this time. How much time will pass before inflation balances out again? That will be a topic for another post, but we can say that it’ll take at least 2-3 years. Too much government intervention might even prolong the process. How can that be? Also, a topic for another post. For now, let’s look at:
What can the government do?
There are two general ways the Federal Reserve lends money to firms, thus growing the economy: They buy corporate bonds and they lend directly (actually through commercial banks) to firms with the bank/discount rate. With the increased availability of money, firms buy more, thus making inflation higher. So, it won’t shock you that the two main ways that the government fights inflation are: Starting Bond-Buy-tapers and making interest rates higher (making money “more expensive”). So, let’s look at what they have done so far:
In the Fed’s July 27-28 meeting, policymakers said that they were keen on reducing bond-buying this year, with the president of the Boston Federal Reserve saying that it would be “appropriate” to begin with the taper this fall. The Fed also intends on starting the taper before any sort of interest rate hike begins. The ECB has already begun “tapering” its Pandemic lending program for businesses, PEPP. Even though this isn’t an equivalent to a bond taper it is a step in the right direction and it may even motivate the Fed to make a quicker decision about its monetary policy.
Conclusion: Are high inflation rates here to stay?
We can analyse what other economists say to that later on. The Fed has made it clear that they deem the current inflation rates to be of “transitory nature”. If that were truly the case, central banks wouldn’t make quick and spontaneous moves to start with bond tapering and anyone who would suggest the possibility of raising interest rates wouldn’t be taken seriously. Actions speak louder than words, so it is thinkable that central banks are only describing this situation as transitory in order to prevent a total economic freak-out. Thus, it seems that high inflation rates are here to stay for some time.
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