Since the financial crisis of 2008, investors and business leaders have become used to low inflation. But this is no longer true. In 2021, prices started going up fast in many parts of the world. And in 2022, the U.S. had the worst inflation it had seen in decades.
The International Monetary Fund (IMF) issued a warning in October 2022. They said that inflation and interest rate hikes by central banks to fight it could threaten the entire global economy. This is a more than a good reason to find out:
- What is inflation?
- What causes inflation? and,
- How do we deal with inflation?
What Is Inflation?
Inflation is when prices go up all over the economy. When prices go up for no reason, money can buy more. This can cause inflation to rise and wages to go up. On the other hand, when prices go up fast, it can be hard on an economy. “Hyperinflation” is a stellar example. This is when people spend their money ultra-fast because prices go up every hour.
Often, central banks try to control inflation. Central banks use interest rates to keep prices from going up too much. When inflation is expected, there isn’t much to worry about. The Federal Bank wants prices to go up by 2% each year.
But since 2021, prices in the U.S. and worldwide have increased faster than anticipated. Because of this, many central banks have raised interest rates because of rising prices. And this could hurt the whole world’s economy and cause a recession in 2023.
What Causes Inflation?
At its core, inflation is caused by too much demand compared to how much is sold. But why does demand go up faster than supply? This can happen for a few different reasons. Understanding them helps to look at the three pillars of macroeconomics. David Moss, author of A Concise Guide to Macroeconomics: What Managers, Executives, and Students Need to Know, organizes his book based on the following:
- output (how much an economy makes),
- money (how much money people have or can quickly get), and
- expectations (what people think will happen next).
All three of these things affect inflation.
Supply Shocks
Supply shocks, such as disruptions to energy supplies, often cause inflation. For example, energy prices rise if a battle shuts down several oil fields. Since energy is a crucial input, other prices climb. “Cost-push inflation” describes this.
A decline in a good’s supply should lead to higher prices because of fewer purchasers. But it’s trickier in practice. For example, a supply shock may generate lasting price increases since few reasonable alternatives exist. Or it could be because nobody knows when the supply shock will end. Or because the initial price hike affects people’s inflation expectations.
Money Supply
Then there’s money supply demand. Moss illustrates that more money causes inflation. With more cash, people discover new reasons to buy, he writes. Unless the supply of goods and services expands, rising consumer demand will drive up prices and fuel inflation. “Too much money chasing too few goods” causes inflation, say economists. “Demand-pull inflation” describes this.
Personal Expectations
In many inflation models, the reason is an unanticipated money supply increase. If everyone feels like demand will increase (because more money is flowing), supply will too. Unexpected demand (or supply) causes inflation.
Inflation expectations affect real inflation. As prices grow, employees’ salaries buy less. If individuals predict rising inflation, they’ll want higher pay to preserve their living level. If firms expect wage inflation, they’ll boost prices, causing a “wage-price spiral” that pushes inflation.
Because expectations matter, central banks work hard to keep inflation expectations “anchored.” That means they aim to convince everyone they can fulfill their inflation goal. They do this so people don’t care about monthly inflation figures. And people will believe inflation will grow by whatever the central bank says.
How Do We Deal With Inflation?
Inflation rarely affects effective money management. But money managers should examine a few factors during inflation. First is how to deal with price inflation. The most basic policy foundation is to have an effective system for changing prices. This method is complemented by how to lower the cost of price shifting.
The second method is to boost morale and communication among staff. In a tight labor market, you may need to do more to keep competent staff. And this might be challenging owing to rising interest rates and wags. Former IT CEO and Harvard Business School instructor Lou Shipley suggests focusing on culture to keep people satisfied and fulfilled in the workplace.
Lastly, you need a plan for maintaining stable levels of inflation. Central banks fight inflation shocks by hiking interest rates, so companies must adapt. Unfortunately, higher rates enhance borrowing costs and divert investors’ focus to short-term gains.