Why Inflation Heats Up and Is So Hard to Cool Down

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The biggest challenge facing the post-pandemic world is how to control inflation. After governments spent lavishly to end the economic collapse of the Covid-19 pandemic, prices began to rise at the fastest rate in decades and central banks began the most aggressive monetary policy in 40 years. When prices are high, people can afford less, businesses struggle to control costs and, in extreme cases, political changes occur.

1. How is inflation measured?

At its most basic level, inflation is an increase in overall prices in the economy over a period of time – monthly or annually, usually – and an accompanying decrease in purchasing power. One common way to measure it is to track changes in the cost of a basket of goods purchased by the average household, including food, housing and basic services. Leading economists surveyed by the World Economic Forum in September warned that inflation today could cause social unrest in low-income countries. The French Revolution was fueled, in part, by rising bread prices.

2. Is inflation always a bad thing?

Isn’t it. In a growing economy, some inflation is expected as incomes rise and demand for goods and services increases. (A general decline in prices, or deflation, is a sign of a weak economy.) The main issue is the rate of inflation. If the rate of inflation rises above wages, the purchasing power of the average person declines, and households and the wider economy suffer. The Federal Reserve Bank of Dallas found that from mid-2021 to mid-2022, American workers face the biggest drop in real wages in about 25 years – about 8.5% with inflation. inflation. They set interest rates and use other policy tools to try to keep inflation at what is seen as a healthy level. In many developed countries, including the US and the European Union, that standard is considered to be 2%.

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3. What drives inflation?

Broad inflationary pressures can come from three streams: supply, demand and expectations. Disruptions in the supply of goods and services have a direct impact on their prices. Demand-side pressures can come when the government increases the money supply by spending more or taxing less, or when the central bank lowers interest rates. If demand is greater than the economy’s output, inflation is a likely outcome. In terms of expectations, the main concern among central bankers is that once inflation is stabilized, it will intensify. That is what happened in the US in the 1970s and early 1980s, until the Fed under Paul Volcker raised the interest rate to 20%, causing a double recession, finally struggling with low prices.

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4. What caused inflation during this period?

There was a supply shock in the early days of the pandemic as Chinese factories closed, shipments slowed and manufacturers found themselves stranded in key locations. In many cases, higher costs were passed on to consumers. The post-pandemic recovery has increased demand for energy, which is consistent with Europe’s low output from wind turbines and a shortage of natural gas. As a result, electricity prices tripled in the second half of 2021. There was a second supply shock after Russia, facing sanctions after its invasion of Ukraine, halted natural gas shipments to Europe. On the demand side, pandemic relief programs in many countries have poured trillions of dollars into the economy.

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5. How does inflation reinforce expectations?

If business owners expect inflation to remain higher than normal, they raise prices. Faced with higher prices, workers demand higher wages. That increases inflation. In extreme cases, it can cause what’s known as a wage-price spiral, where higher wages and higher costs become invisible to what’s happening in the larger economy. That is seen as unlikely at this time, since inflation is driven by food and energy prices, not labor costs.

6. How do central banks fight inflation?

The main way central banks deal with rising prices is by raising the interest rates at which banks lend to each other. The idea is that when borrowing is too expensive for banks, they will pass it on to companies and consumers, who will borrow and spend less, thus cooling the economy. But interest rates are often called a blunt instrument, meaning they are difficult to use accurately against anything that is ailing the economy. Raising prices can stop inflation, but it weakens overall economic growth, and there is always a risk of inflation.

More stories like this are available at bloomberg.com

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