As prices continue to increase across a broad range of spending categories, many Americans are finding that their paychecks aren’t going as far as they used to. That’s probably because in last year’s June, as measured by the Consumer Price Index, inflation rate was standing at a whopping 9.1%, the highest it’s been in over four decades.
So, what’s given rise to higher prices at the gas pump and or at your local grocery store? Well, there are a variety of different causes — from international conflict to changes in what consumers purchase.
What is inflation?
First off, let’s establish some basics about inflation, which is the increase in the price of goods and services over a period of time. In order to measure inflation, economists use a price index to look at price changes across a number of different goods and services.
Inflation is a sustained increase in the general price level of goods and services in an economy over time. This means that as inflation occurs, the purchasing power of currency decreases. In other words, as prices go up, the same amount of money can buy less than it could before.
There are various causes of inflation, including an increase in the supply of money or credit in an economy, increased demand for goods and services without a corresponding increase in supply, or external factors such as natural disasters or geopolitical events.
Inflation is typically measured by tracking changes in the consumer price index (CPI), which is a basket of goods and services that reflects the spending habits of an average consumer. The CPI is used to calculate the inflation rate, which is the percentage change in the price level from one period to another.
Inflation can have both positive and negative effects on the economy. On the one hand, moderate inflation can encourage economic growth by making it easier for businesses to raise prices and generate more revenue. On the other hand, high or unpredictable inflation can erode the value of savings and investments, discourage lending and investment, and make it difficult for consumers to plan for the future.
Although the Federal Reserve uses a different price index to measure inflation — the Personal Consumption Expenditures, or PCE Index — which similarly measures price changes among goods and services.
Lastly, the core inflation rate refers to an index that excludes volatile spending categories such as food and energy, and can be a useful index for economists since food and energy prices can fluctuate significantly.
What’s considered healthy inflation rate?
Central banks of developed economies, including the Federal Reserve in the U.S., always monitor inflation. The Fed has an inflation target of approximately 2% and adjusts monetary policy to combat inflation if prices rise too much or too quickly.
This is the target rate that many central banks, including the Federal Reserve in the United States, aim for when setting monetary policy.
Inflation at this level is generally viewed as a sign of a healthy economy, as it indicates that prices are rising at a moderate and predictable rate. This can encourage spending and investment while allowing businesses to adjust their prices and operations accordingly.
However, it’s important to note that what constitutes a healthy inflation rate can vary depending on the economic conditions and goals of a particular country or region. In some cases, a higher or lower inflation rate may be more appropriate to achieve specific economic objectives. For example, during a recession, a slightly higher inflation rate may be desirable to encourage spending and investment, while in an economy with a large trade deficit, a lower inflation rate may be needed to prevent the currency from losing value too quickly.
What causes the inflation?
In general, inflation can be caused by a variety of factors, including:
- Increase in the money supply: When a central bank increases the money supply in an economy, it can lead to inflation as there is more money available to spend, but the same amount of goods and services to buy.
- Increase in demand: If demand for goods and services increases without a corresponding increase in supply, prices can rise as consumers compete for limited goods and services.
- Increase in production costs: If the cost of producing goods and services increases, businesses may pass those costs onto consumers in the form of higher prices.
- External factors: Natural disasters, geopolitical events, and changes in trade policies can also lead to inflation by disrupting supply chains and driving up the cost of goods and services.
In addition, inflation expectations can also play a role in causing inflation. If consumers and businesses expect prices to rise, they may increase their own prices and wages in anticipation, which can create a self-fulfilling cycle of inflation.
It’s important to note that inflation is often a complex and multi-faceted issue that can have a wide range of causes and effects. Central banks and governments typically use a variety of tools, such as monetary policy and fiscal policy, to manage inflation and promote economic stability.
The current high inflation rate can be attributed to many different factors, many of which are a result of the Covid-19 pandemic.
Rising prices may be attributed to three general causes — increases in household demand and supply-chain shortages due to the pandemic, the war in Ukraine and the presence of a strong labor market.
Generally, the inflation story goes something like this: At the start of the pandemic, consumers began spending less because of lockdowns, and in turn, started saving more. Then, when Covid-19 restrictions eased, people started spending more again (especially online). Companies, however, couldn’t keep up with this increased consumer demand — many of them had reduced production because of the pandemic and experienced shipping delays as well as shortages in labor and key inputs.
The result of all these things? Higher prices for most goods and services.
While price increases were seen across multiple categories, some of the largest price hikes occurred in gasoline, shelter, and food — the year-over-year increase in food prices was over 10%, while for shelter it was 5.6% and for energy prices, 41.6%.
While gas prices have declined in the past months, they still remain high — the American Automobile Association reports that the national average for a gallon of gasoline is $3.4. As gas prices are high, it becomes more expensive for the logistics companies to ship products. And of course, increased shipping costs increase product price in the end.
Just as there are many causes of broad-based inflation, there are many factors that have given way to higher energy prices as well. Perhaps most notably is Russia’s invasion of Ukraine and Western countries’ resulting sanctions which put severe limits on the import of Russian oil. Both events played a significant role in rising energy prices and supply-chain issues, as has fluctuating consumer demand for gasoline.
How the government is dealing with high inflation rate?
There are several ways that governments can try to address high inflation rates:
- Monetary policy: Central banks can use monetary policy tools, such as raising interest rates, to curb inflation by making it more expensive to borrow money and reducing consumer spending.
- Fiscal policy: Governments can use fiscal policy tools, such as raising taxes or cutting spending, to reduce aggregate demand and slow down inflation.
- Price controls: Governments can also impose price controls on goods and services that are deemed essential, such as food or healthcare, to prevent prices from rising too quickly.
- Wage controls: In some cases, governments may also impose wage controls to prevent wages from rising too quickly and fueling inflation.
- Supply-side policies: Governments can implement policies that increase the supply of goods and services, such as deregulation or investment in infrastructure, which can help to reduce prices and ease inflationary pressures.
It’s worth noting that each of these approaches has its own strengths and limitations, and there is no one-size-fits-all solution to high inflation. Governments must carefully consider their options and balance the need to control inflation with other economic and social objectives.
Currently, the Federal Reserve seeks to control inflation by influencing interest rates. When inflation is too high, the Federal Reserve typically raises interest rates to slow the economy and bring inflation down. Interest rate hikes reduce the economy growth because borrowing becomes more expensive.
For example, someone wishing to borrow 500k $ for house purchase may delay such expense if interest rates are too high, this automatically reduces the demand for real estate which consequently lowers the real estate prices. That’s how inflation rate goes down.
But the main concern economists see with Fed raising interest rates is that it should be done before the recession hits, in other words while economy is still booming. Because if it is done at the times of recession, then it may completely break the economy and it may transform into a stagflation where we see a high inflation rate plus recession, which is the worst case scenario.
And as you could already see banking sector has started collapsing a few weeks ago with such giants as Silicon Valley bank in the U.S. and Credit Suisse in Switzerland going down. That’s why everyone’s expecting Fed to not raise interest rates any more as they already did enough harm to the economy.
