Coming to terms with inflation

Inflation is a general increase in the price of goods and services. Its causes can vary but, at the most basic level, inflation arises from excess demand in the economy resulting from rising demand and/or falling supply. The post-COVID-19 high-inflation episode typifies these dynamics. As mobility restrictions were eased, economies experienced increased demand for services as consumers spent excess savings accumulated during the pandemic. 

At the same time, supply was dragged by residual pandemic disruptions and higher energy costs in the wake of the Russian invasion of Ukraine. As the mismatch between rising demand and stagnant supply widened, inflation surged. 

Maintaining price stability—defined as a low inflation rate—is a key policy objective for central banks. This is because empirical evidence across many countries and over time has shown that high inflation is detrimental to economic growth, and disproportionally affects the poorest and the most vulnerable.

Purchasing power is defined as the amount of goods and services which can be acquired using a unit of currency. By increasing the average price level, inflation reduces purchasing power. Wage indexation—whereby wages rise in response to higher inflation—protects purchasing power to some extent, but it is not adopted in all countries and, where present, it typically covers a low share of poorer workers’ employment contracts. 

Additionally, wage indexation can trigger a wage-price spiral: businesses increase prices to match the increased cost of labor, workers ask for higher wages in response, and so on. This can lead to very high inflation episodes—that is, cases of ‘hyperinflation’ with price increases of 50% or more per month. With hyperinflation, purchasing power falls very quickly, thus no one wants to hold much money in their pockets. The functions of money as store of value, unit of account, and medium of exchange break down, creating substantial disruptions to economic activity.

The consumer price index (CPI) measures changes in prices for a basket of goods and services consumed by a typical household in the economy. The concept recognises that the prices of some goods and services are more relevant than others for consumers. It is consumer prices which determine the purchasing power of households’ disposable income, thus affecting overall consumption and demand in an economy. As such, it is important to monitor consumer price index inflation closely for economic policy and other purposes.        

Monetary policy comprises the actions that central banks (or, in some cases, governments) can take to influence the cost of borrowing. While monetary policy strategies can vary across economies, monetary authorities typically intervene by setting an overnight interest rate—the rate at which commercial banks and other financial institutions borrow money from the central bank. This rate acts as a lever for all other interest rates in the economy, influencing mortgage rates, credit card payments, all the way to the rate at which the government borrows to finance its spending. Central banks lower interest rates to boost domestic demand and, thus, raise prices. To curb inflationary pressures, they tighten monetary policy by hiking interest rates, thus putting downward pressure on demand.

Interest rates determine the cost of borrowing and the rewards for saving. For borrowers, the interest rate is the amount charged for borrowing money, expressed as a percentage. The higher this lending rate, the greater the amount to be paid back for any given size of a loan. Savings rates define the percentage return on savings. The higher the savings rate, the more will be paid into a depositor’s account for any given amount of savings. As well as policy rates, lending and savings rates are influenced by several other factors, including time to maturity and risk of default.