Decoding Inflation: A Guide for the Curious Mind

Inflation: When Your Money Shrinks

Imagine you had ?100 to buy a delicious Chocolate ice cream cone last year. Now the same ice cream cone costs ?120! Thats inflation in a nutshell - when prices slowly creep up over time, and your money just doesn't stretch as far as it used to.

Let us familiarize ourselves with a new term to understand inflation in a more profound way - "Purchasing Power", which simply means how much your money can buy. So, the ?100 which could have bought me an ice-cream last year has last lost its ability to do so today which means its purchasing power has decreased.

Well now you might be thinking, "It's not just the ice-cream, almost everything seems a bit costlier than it did earlier!" You're absolutely right! Inflation does not target a specific item; it is a general increase in the price of all goods and services in a country. And since it affects a whole country, it is highly impactful.

Effects of Inflation

Inflation can impact the economy in several ways.

• Decreasing Purchasing power
• Interest Rates rise
• Wage-Price Spiral

Let go over these topics in detail.

Increase in Interest Rates:

Central Banks often raise interest rates during periods of inflation. Higher rates make borrowing more expensive, reducing the incentive for people and businesses to take loans. This decrease in borrowing leads to lower overall demand in the economy, helping to slow down the rapid rise in prices.

But that’s not all—there’s an added benefit! Higher interest rates can attract foreign investments. Why? Because investors are drawn to economies with better returns. This influx of foreign capital strengthens the local currency, which can make imported goods cheaper and further helps in stabilizing inflation.

Wage-Price Spiral:

Inflation can only arise if labor or business, or both, have pricing power - Bill Miller

When the prices of goods and services rise, workers feel the strain as their cost-of-living increases. To keep up with these rising expenses, employees demand higher wages from their employers. However, this creates a ripple effect—businesses face higher operating costs due to increased wages. To maintain their profit margins, they pass these additional costs onto consumers by raising the prices of goods and services even further. And so, the cycle continues, feeding into itself in a seemingly endless loop that can make inflation harder to control.

Measuring Inflation

Measuring inflation is necessary for the following major reasons:

• Maintaining Price Stability: Central banks use inflation data to set interest rates and implement monetary policies aimed at keeping prices stable. Stability ensures predictable economics conditions for businesses and households.
• Economic Planning and Forecasting: Accurate inflation metrics allow businesses to plan their pricing strategies, production costs, and investments. Governments also use the data to forecast future economic conditions and draft appropriate fiscal policies.
• Global competitiveness: Inflation impacts the value of a country's currency. Monitoring it ensures competitiveness in international trade by keeping exports affordable and import manageable.

Consumer Price Index (CPI) Measurement Method

It’s a warm Sunday evening, and you decide to visit your local grocery store. As you walk through the aisles, you pick up a few essentials: some fresh fruits, vegetables, bread, milk, and a bottle of cooking oil. You also grab a few snacks like chips and cookies. These items are things you typically buy every week, and they make up what we call your "basket of goods."

Now, this basket of goods is not just a random collection of products—it represents the everyday purchases that a typical consumer might make. The idea is that by tracking the prices of the items in this basket over time, we can measure how inflation affects your cost of living.

The basket of goods includes a mix of products and services, like food, transportation, housing, healthcare, and entertainment, that reflect what people commonly spend money on.

Each item in this basket has a weight, or a level of importance, based on how much of your income is typically spent on it. For example, you might spend more on milk and bread than on chips or cookies, so these items will have a higher weight in the basket. The price of each item is tracked and then compared to its price in a previous year (called the base year). The changes in the prices of these items over time are then used to calculate the Consumer Price Index (CPI), which helps measure inflation.

For instance, imagine last year you bought a loaf of bread for ?30, a bottle of milk for ?50, and some fruit for ?100. This year, the prices of bread and milk have gone up to ?35 and ?55 respectively, and the fruit costs ?120. By tracking the prices of the items in this basket, economists can calculate how much more (or less) you’re paying for the same goods this year compared to last. This tells us whether inflation is increasing, decreasing, or staying the same. It also reflects how your purchasing power is changing—whether your ?100 will buy you the same amount as it did last year or if it’s buying less.

So, when you see the prices at your grocery store rising, it’s not just about individual items—it's a reflection of inflation in the economy, which is tracked using your very own "basket of goods."

Types of Inflations:

Demand-Pull Inflation: Imagine that the next book in the Harry Potter series is out and there is a huge surge in demand. Fans everywhere are excited to get their hands on the book. People are lined up at bookstores, pre-orders are through the roof, and demand is far greater than the supply available. As a result, bookstores realize they can increase the price of the book because so many people are willing to pay a premium to get it first. The surge in demand pushes the price up. This is a classic example of demand-pull inflation.

In general, demand-pull inflation occurs when demand for goods and services exceeds supply, causing prices to rise.

Cost-Push Inflation: Now, imagine you're at your favorite bakery, and you go to buy a loaf of fresh bread. Suddenly, you find out that the price has gone up! The bakery owner explains that the cost of wheat has risen and so have the transportation and labor costs. To cover these increased expenses, they had no choice but to raise the price of bread. This is called the cost-push inflation—when the cost of production rises (due to higher raw material costs, wages, etc.), businesses pass these costs onto consumers by increasing prices.

It’s like a ripple effect in the economy, where the cost to make goods increases, causing the prices of those goods to rise.

Built-In Inflation: It is also referred to as the "Wage-Price Spiral". Let’s say the prices of goods keep rising, and workers start to feel the pressure. To cope with the higher cost of living, they demand higher wages from their employers. The employers, facing higher wage costs, raise the prices of their products or services to maintain profit margins. In turn, workers demand even higher wages to keep up with the increasing cost of goods, and the cycle continues.

Hyperinflation: Imagine opening your wallet and finding that your money is worth far less than it was yesterday. A loaf of bread that cost ?50 is now ?500, and by the end of the day, it might cost ?1000. People rush to spend their money as fast as they can because its value is falling by the minute. This is hyperinflation—an extreme and uncontrollable rise in prices, often caused by a collapse in the value of a country's currency. It happens when there is excessive money printing by the government, a collapse in production, or a loss of confidence in the economy. It leads to rapid, out-of-control price increases, which can devastate an economy.

Key Highlights of Inflation Trends:

Inflation has always been a critical barometer of economic health, reflecting the complexities of supply, demand, and fiscal policy. Let’s trace its story through distinct periods of recent history, starting from the early 2000s to the post-pandemic recovery era.

Early 2000s:

• Between 2000 and 2005, global trade volumes increased by approximately 30%, driven by trade agreements such as China joining the World Trade Organization in 2001.
• China’s exports grew by an average of 25% annually during this period, flooding global markets with affordable goods and keeping inflation in advanced economies below 2-3% annually.
• Inflation rates in the U.S. averaged 2.2%, while the Eurozone maintained levels near 2.1%, within central bank targets.

2008: Global Financial Crisis

• In 2008, global inflation averaged 6.4% but advanced economies worldwide, with inflation playing a secondary but significant role.
• Central banks slashed interest rates to near zero and launched unprecedented quantitative easing programs, with the Federal Reserve expanding its balance sheet from $870 billion in 2007 to $2.2 trillion in 2009.
• Inflation surged in emerging markets like India and Brazil, reaching 9% and 6%, respectively, as depreciating currencies increased import costs.
• The world seemed to unravel as banks failed and markets crumbled. Central banks stepped in as saviors, pumping money into the system to revive demand. However, this led to debates about future inflation risks. In developing countries, the pain was twofold: while economies slowed, inflation soared, making essentials like food and energy increasingly unaffordable.

Early 2010s:

• Inflation rates remained subdued in advanced economies, averaging 1.5-2%, as central banks kept interest rates low. Japan’s deflationary struggles persisted, with inflation hovering near -0.1% in 2013.
• Brent crude oil prices increased by 150% between 2009 and 2012, peaking at $126 per barrel in 2012, contributing to inflation in energy-dependent economies.
• Imagine a cautious recovery—like Fawkes - the phoenix rising slowly from the ashes. Advanced economies tiptoed through low-interest environments, wary of reigniting a crisis. In contrast, emerging markets grappled with a different reality: inflation that tested central banks’ resolve and citizens’ patience.

COVID-19 Pandemic:

• Global shipping costs skyrocketed, with the Baltic Dry Index peaking at 5,650 points in September 2021, up from an average of 1,290 in 2020, reflecting the severe supply chain crisis.

• Governments deployed fiscal packages amounting to $16 trillion globally, fueling demand-pull inflation once economies reopened. U.S. inflation surged from 1.4% in 2020 to 7% in 2021.
• Oil prices rebounded sharply, with Brent crude jumping from $19 per barrel in April 2020 to $80 by the end of 2021. In India, the price of domestic cooking gas cylinders (LPG) rose from approximately ?581 in January 2020 to over ?900 by late 2021, placing an additional burden on households. Petrol prices in major cities crossed the ?100 per liter mark, reflecting the combined impact of higher crude oil prices and increased taxes.

Post-Pandemic Recovery:

• The Russia-Ukraine conflict in 2022 disrupted energy and food supplies, causing inflation in the Eurozone to reach a record-high 10.6% in October 2022.
• The Federal Reserve raised interest rates from 0.25% in March 2022 to 5.25% by mid-2023, one of the fastest tightening cycles in decades.
• Green energy investments surged by $1.1 trillion in 2022, reshaping inflation dynamics as economies transitioned away from fossil fuels.

The journey through inflation's history reveals a dynamic interplay of global events, economic policies, and societal shifts. From the rapid globalization of the early 2000s to the shocks of the 2008 financial crisis, the recovery-driven optimism of the early 2010s, and the unprecedented disruptions of the COVID-19 pandemic, inflation has been shaped by forces far beyond simple demand and supply dynamics.

The story of inflation is far from over—it's a continuous narrative that evolves with each global event, changes int he policy, and economic breakthrough of some sort. History shows that being resilient and adaptable is crucial to dealing with this hot potato.