Everything You Need to Know About Inflation

'Inflation is when you pay fifteen pounds for the haircut you used to get for five pounds when you had hair.'

Inflation is the buzzword on everyone's lips this year. You see it across all parts of life; there's no way to avoid it. Inflation used to seem controllable, but it's now a major economic problem.

We are going to explore how inflation became such an issue, what made it worse, and what the consequences are for our economy.

WHAT CAUSES INFLATION?

There are three drivers of inflation: cost-push, demand-pull and follow-on factors.

Cost-push inflation is exactly as it sounds - an increase in specific costs, driving up prices across the board. In recent years, lockdowns have led to factories and ports closing. This has cut supply of goods and pushed up their prices.

These supply constraints were worsened by the Russia-Ukraine War, which reduced oil and gas supplies - both of which are important inputs for the production of most goods.

If companies face higher costs, they will pass them on to consumers as higher prices. This is cost-push inflation.

At the same time, demand factors have also pulled up prices. For many people, COVID caused financial ruin. But for others - typically the better off - working from home meant no transport costs. Border controls meant no holidays. Government schemes meant more cash.

More money, and fewer items on which to spend it. Demand skyrocketed for areas where you could spend money. Cars, houses and luxury goods saw booms, aided by low interest rates. In response, the prices of these goods rose.

The third cause of inflation is less a trigger but more an engine that keeps inflation going. Once it takes hold, expectations for inflation also rise. Companies increase prices by more than normal, as they expect future inflation to be higher. And workers increase their wage demands (the wage-price spiral).

In other words, the way people respond to high inflation causes yet higher inflation to persist. These follow-on factors are a self-fulfilling prophecy. This is why, once inflation begins, it is difficult to slow down. Looking at charts of inflationary periods, it's clear that inflation rises quickly, but takes time to fall. Once people have seen high prices, it takes time for them to adjust down their expectations for the future.

As such, inflation is like the proverbial genie - once it's out of the bottle, it's hard to put back in.

WHAT'S THE FIX?

It depends. Just as there are different causes of inflation, there are different cures.

To solve cost-push inflation, you need to fix the supply-side issues. For example, supply-chain pressures reduced when economies reopened after COVID. But the world's lack of forward planning on energy means it has not yet replaced the oil & gas supplies lost through the Russia-Ukraine War.

In the long-term, having better energy substitutes and supply chains will help, but these take time. In the meantime, the easier fix - at first glance - is to reduce demand. How? By raising interest rates.

Higher interest rates raise the cost of borrowing for individuals, for companies and for governments. This increases the money spent on interest, and reduces money spent in the economy.

Eventually, the reduction in demand through higher interest rates will be enough to reduce inflation - but at what cost? It's a double-edged sword - higher interest rates can fix the inflation problem, but often lead to a recession.

WHAT HISTORY TEACHES US

Some governments have very unwisely tried to borrow, spend and print their way out of inflation. This has had severe consequences.

In the 1920s, Germany faced debts from World War I. Instead of raising taxes to pay these debts, their response was to print more money. This strategy was a disaster. By printing money, they simply diluted its value.

By doubling the money in circulation, the value of money halves. In other words, it takes twice as much money to buy the same goods and services - i.e., those goods cost twice as much. This is inflation.

Germany's experiment was such a failure that it was a key contributor to the rise of Hitler. Printing money doesn't help; it simply perpetuates the problem.

WHAT IT MEANS FOR YOU

Low, stable inflation is important. It is something we take for granted when we have it, but which we can see is important when we don't. It allows individuals, companies and governments to plan, without fear of volatility.

Over your lifetime there will be inflation. Sometimes it will be higher, sometimes lower, but you can be sure that prices will rise over time. If you hold your money in cash, where the interest rates paid to you are below the rate of inflation, the value of your money will erode over time.

Inflation is like a thief in the night - you don't know what you're losing at the time, but you find out when it's too late. If you don't invest to beat inflation, your hard-earned savings will bleed away in value.

Perhaps you'll look at asset prices and see the stock market and housing market falling in value. Isn't cash a better place for your money, you might ask? In the short-run, perhaps, but it's hard to time that right. In the long-run, being invested is the best way to beat the effects of inflation.