- In simple terms, it is the rate at which prices rise in a given month compared to the same month in the previous year & Any economy, in order to function well, needs the right level of inflation, which is low inflation
- When inflation in any country is low, people are happy. The money that they earn proves to be sufficient to meet their expenses. They are not in a perpetual race to somehow earn more to be able to keep up with their expenses. When inflation reaches a high level, people find it very difficult to meet the expenses from their income, and that’s not a happy place to be in.
- Right now, inflation is at very high levels across the world. It is currently higher in developed countries than in developing countries. In the US, it is at a more than four-decade high. In the UK, it is at a more than three-decade high. It is a two-and-a-half-decade high in the euro area or the countries that use the euro as its currency.
- Now in order to control inflation, the central banks of these countries and areas have been raising interest rates. Let me explain how this works.
- Inflation can happen from the demand side or the supply side. Supply-side inflation happens when there is a shortage of goods and services, so prices go up. This was the case immediately after the covid pandemic started. Supply chains broke down. Further, due to lockdowns across different parts of the world, the production of goods slowed down.
- Then there is the demand side. When demand increases, too much money chases the same goods and services. So the supply may not go up simultaneously, leading to prices going up.
- Central banks are in a position to control demand-side inflation by increasing interest rates, which is what they are trying to do right now. When central banks increase the interest rates, the cost of borrowing goes up; that is, the EMIs go up.?
- When EMIs go up, people are likely to borrow less than they did in the past. At an aggregate level of the economy, this leads to less money chasing the same goods and services. This helps rein in consumer demand and, in the process, the rate of price rise or inflation
- As interest rates go up, not just lending rates, but deposit rates also go up, albeit at a slower pace. When a higher rate of interest is on offer on a fixed deposit, there is an incentive for savers to save more than spending that money now. Higher interest rates incentivize the postponement of consumption. Hence, lesser money chases goods and services and helps rein in consumer demand and inflation.
- Rising interest rates don’t just raise the cost of borrowing for individuals, they do so for firms as well. As interest rates go up, firms are likely to borrow and invest less. Once this happens, the creation of new jobs slows down. This leads to a slowdown in hiring and, in the process, a slowdown in the rate at which salaries and incomes have been going up.
- The rate at which salaries and incomes have been going up is referred to as wage inflation. Once wage inflation starts slowing down, overall inflation also slows down. In fact, this dynamic can even lead to higher unemployment in the economy and that helps control inflation
- Finally, there are asset bubbles that need to be burst. Once the covid pandemic broke out, interest rates fell, and large parts of the developed world saw a massive rise in real estate prices. This dynamic also pushes up the overall rate of inflation. Now once interest rates go up, home loan EMIs also go up. This gradually leads to the demand for real estate falling, and in the process, real estate prices come down.
- This helps control inflation in two ways, First, as home prices come down, the building of new homes starts to fall. This means that the demand for everything that goes into the building of the real estate, that is, bricks, sand, wood, cement, steel, ceramics, etc., also falls. This fall in demand leads to lower prices of these goods and helps control the rate of inflation.
- Second, once home prices go up, home rents also go up. And home-rents are an important constituent of how inflation is calculated. Once home prices start to fall, home rents come down as well, and that helps in bringing down the rate of inflation
- Now the question is, the central banks around the world have been raising interest rates for more than a few months now, but the rate of inflation continues to remain high through large parts of the world. Why is that?
- That's because monetary policy is not Maggie. It takes time to see the results & there is a certain time lag between a central bank raising interest rates and inflation coming under control. There is no fixed answer to the question of how soon inflation starts to fall after a central bank starts to raise interest rates.
- Also, there are contracts in place. Salary increments usually happen once every year. And once they are in place, any firm is unlikely to cut salaries just because a central bank is raising rates. Further, rental contracts are also signed annually. These factors limit the impact of central banks raising interest rates to control inflation
- And again the nature of inflation is very psychological. Once people start believing that high prices are likely to remain the order of the day, they start to incorporate this understanding into their financial decisions. This means if inflationary expectations in people’s minds are high, they can get built into higher wage demands. This can lead to higher wages and firms then need to pass this on to the end consumer in the form of a higher price.?
- This is what we are seeing playing around the world, So, inflationary expectations are currently unanchored, meaning that many people don’t believe that central banks will be able to control inflation.
- Typically, the way a central bank tries to handle such a situation is to convey its seriousness about controlling inflation to the world at large so that people and firms start incorporating this in their decisions by demanding lower pay hikes and increasing prices at a slower pace. But this is not happening.
- But on the ground individuals and firms aren’t taking the message of central banks of controlling inflation very seriously. And given that they aren’t building that message into their financial calculations. This means that the demand for higher wages than in the past continues. At the same time, firms believe that prices will continue to remain high. This ensures that inflation continues to remain high despite higher interest rates.
- Now, given that central banks have been unable to control inflation up until now, they might have to keep increasing interest rates & it might turn out that they might overdo this and increase interest rates to such a level that it might lead to the economy slowing down or even contracting in parts of the developed world.
- It’s also possible that they may not raise interest rates enough, and high inflation might continue to be the order of the day & high inflation hurts the poor the most.
- Central banks around the world got around to raising interest rates to control inflation only this year, whereas inflation has been on the high side since last year. They thought that inflation would be transitory, that it would soon disappear. But that didn’t turn out to be the case.
- And that my friend is why we are here Today…Now you know all about Inflation!
? Assistant Supervisor
2 年Very well explained sir with structured approach, Easy to understand.
Founder -Coeus HR Consultants (P) Limited | Executive Search | Leadership & Career Coaching | Podcaster |
2 年Insightful , even for a layman !