Global Economic Outlook

How big a threat is inflation?

Published : July 31, 2021 13:36 IST
Inflation worries are back. Some warn of a return to the 1970s, while others downplay recent upticks.

As inflation accelerates globally, we explore how likely is the risk of faster-growing inflation and what it might mean for consumers. We start with a quick reminder of what inflation is, how it's measured, what causes it and why it's important.

What is inflation?

A rise in prices across an economy, leading to erosion of the purchasing power of consumers. In other words, the money in your pocket buys less.

Inflation can be contrasted with deflation, which occurs when the purchasing power of money increases and prices decline.

Then there is hyperinflation, which is often described as a period of inflation of 50 per cent or more per month. The most infamous example is the German Weimar Republic in the early 1920s. Money flooded the economy and its value fell to the point where people needed wheelbarrows of cash to buy a loaf of bread.

Types of price indexes

Multiple types of baskets of goods are calculated as price indexes. The most widely used are the Consumer Price Index (CPI) and the Wholesale Price Index (WPI).

The CPI is a measure of the weighted average of prices of a basket of goods and services for primary consumer needs: transportation, food, and medical care. Changes in the CPI are used to assess price changes associated with the cost of living, making it one of the most frequently used statistics for identifying periods of inflation or deflation.

The WPI measures changes in the price of goods in the stages before the retail level, and is often a good predictor of changes in the CPI.

Demand-pull inflation

Demand-pull inflation occurs when an increase in the supply of money and credit stimulates demand for goods and services in an economy to grow more quickly than the economy's production capacity. With more money available, positive consumer sentiment leads to higher spending, and this increased demand pulls prices higher.

This is particularly relevant today as governments in effect have opened their money taps announcing stimulus packages worth trillions of dollars. Central banks have also been trying to stimulate the COVID-hit economy by buying government bonds, among other things.

The European Central Bank and the U.S. Federal Reserve have been pursuing this policy, known as quantitative easing (QE), to counter deflation, after some countries experienced negative interest rates, due to fears that deflation could take hold and lead to economic stagnation.

"The recovery is well advanced in the U.S., and the Biden fiscal stimulus will add to rising demand. There is a risk of getting behind the curve," Charles Bean, a professor at the London School of Economics, told DW.

Cost-push inflation

Cost-push inflation is a result of the increase in prices working through the supply chain leading to higher costs of the finished product or service. There are fears that the pandemic-induced supply-chain disruptions and shortages of shipping containers and semiconductors, which are driving up production costs, would eventually lead to higher prices as more and more producers choose to transfer the burden on consumers.

Built-in inflation

Built-in inflation is related to adaptive expectations, the notion that people expect current inflation rates to continue in the future and demand higher wages to maintain their standard of living, which in turn results in higher cost of goods and services as firms seek to maintain their profit margins — the so-called wage-price spiral.

"The main problem is one of inflationary expectations, something central bankers are most acutely aware of," Bean said.

"They [inflationary expectations] push up wages, and the classic wage-price spiral can ratchet up. And this becomes very difficult to reverse, without higher unemployment to create some spare capacity and lower wages," he said.

Robert Reich, who served in the administrations of presidents Gerald Ford and Jimmy Carter, disputes this theory of inflation in the current environment. "First, pent-up demand is at most temporary. Second, most of it is found in higher-income people who don't spend as much as they earn. Lower-income people tend to spend more than they earn and have little or no pent-up demand," Reich told DW.

Is inflation good or bad?

Many economists advocate a middle-ground of low to moderate inflation of around 2 per cent per year. When inflation breaches that figure some benefit and others lose out. Inflation is usually considered a problem when it goes above 5 per cent, Brigitte Granville, a professor of economics at Queen Mary University, London, told DW.

If inflation causes a currency to decline, then it can benefit exporters by making their goods more affordable when priced in other currencies. People with assets that are priced in a particular currency, like property or commodities, may like to see some inflation as that raises the price of their assets.

Inflation can also increase profit margins and reduce debt in real terms. It can benefit borrowers because the inflation-adjusted value of their outstanding debts shrinks. However, higher inflation tends to harm savers as it erodes the purchasing power of the money they have saved.

People holding assets denominated in currency, such as cash or bonds, may also not like inflation, as it erodes the real value of their holdings. Moreover, if central banks felt obliged to tighten monetary policy to check rising prices, it could cause a sharp correction in financial markets, which have been pumped up by a decade of QE-style liquidity injections.

"Millions of middle-class households which have been placing increasing proportions of their savings in mutual funds invested in equities would suffer," Granville says.

However, inflation of 3 per cent or 4 per cent could be positive for many economies at the moment. There are economists who argue strongly that it would reduce the debt overhang in real terms, for example.

Is there a trade-off between inflation and unemployment?

One of the key arguments that the Fed Reserve has been making to justify maintaining its accommodative monetary policy despite a steep rise in prices is that there are still millions of people unemployed in the U.S. and that a premature winding down of stimulus measures could hurt their job prospects. If the cost of keeping down inflation is higher unemployment, many feel it isn't a price worth paying.

"Those who worry about inflation tend not to worry about the social costs of structurally high unemployment or underemployment," Reich says. "More social spending on unemployment insurance and the safety net, more crime, more illness, more deaths of despair," he adds.

Transitory inflation?

Central bankers say the current rise in prices is a temporary fallout of the economic disruptions caused by the pandemic. Supply chains have been disturbed by demand first collapsing and then coming back quickly, making prices volatile. They argue that factors pushing up prices would disappear once the economy normalizes, pandemic-hit businesses return to full capacity and supply chain issues are resolved.

Others, mainly in the U.S. where inflation is running at a 13-year high, are skeptical. They warn that high inflation could last longer than central bankers currently think.

Political argument

"The concern about inflation, especially in the U.S., is driven mainly by right-wing economists who see a relationship between state spending, debt, debt monetization and inflation — all of which are contestable linkages," Will Hutton, at the LSE’s Centre for Economic Performance, told DW.

Reich also notes that the fear of inflation is mostly political and is based primarily on the most recent bout of double-digit inflation in the U.S., in the late 1970s under President Jimmy Carter.

"He wasn't to blame, of course. Much had to do with dramatic increases in oil prices and other anomalous factors. But the Fed's response (raising interest rates to the point where the U.S. was plunged into a deep recession, which essentially caused voters to throw Carter out) has not been forgotten," he said.

Since the late 1970s, there has been no need to worry about inflation, especially in the U.S., because the structure of the economy has moved in an anti-inflationary direction, Reich says.

Anti-inflationary structural changes include a dramatic shrinkage of the unionized sector from 35 per cent of private-sector workers in the 1950s to only 6.2 per cent now, which means wage-price inflation is almost impossible; technological changes that have made it very cheap for companies to add capacity both within the US and internationally; and continuing high structural unemployment and underemployment, he said.

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