Let’s Be Clear: Inflation Is Here to Stay

By Frank-Jürgen Richter

April 22, 2022

Inflation levels have been at historic highs. In the US, inflation levels have registered a 40-year high, hitting 8.5% currently the fastest surge since 1981. A steep climb in fuel prices exacerbated by the Russia-Ukraine conflict, and continuing impacts on account of the pandemic, are making US households feel the dent on their household budgets. Current inflation levels have been especially painful for low-income families.

The two primary causes for inflation are ‘demand-pull’ and ‘cost-push’. Both inflation types contribute to an aggregate increase in prices for goods and services in an economy. Demand-pull inflation occurs when higher consumer demand leads to an increase in prices, while cost-push inflation is seen when supply or input costs make it necessary to raise prices.

Inflation levels were a worry coming into 2022. Prevailing theory upholds an arbitrary 2% target. Analysts, meanwhile, do not take into account the many changes that are inherently inflationary – such as demographics, build back better schemes, and above all, the cost of energy. What is the correct level of inflation? Is inflation control desirable, even necessary? How can its effects be safeguarded against?

Horasis is organizing the Horasis Global Meeting on 19 May 2022 to examine and evaluate such developments. The one-day virtual event will see participation from a diverse range of people, spanning members of governments, businesses, academia, and the media. The goal is to deliberate on pressing issues that undermine progress and arrive at actionable solutions that can ensure shared prosperity.

Can Inflation be Controlled?

The inflation rate, in simple terms, is the overall price increases of goods and services in an economy. Inflation levels, in turn, impact interest rates that are paid to depositors on their savings, and also the interest rates that borrowers will be liable to pay on their loans. Additionally, inflation also affects pensions and government benefits.

In a large emerging economy such as India, its inflation rate has averaged between 5-6% over the past decade. Meanwhile, average inflation rates in developed countries are typically in the 2-3% range.

Over the years, four key strategies that central banks have implemented to arrest and lower inflation levels include the following:

1) exchange-rate pegging;

2) monetary targeting;

3) inflation targeting; and

4) inflation reduction without an explicit nominal anchor, or the ‘just do it’ policy.

The fourth strategy was implemented by the US Federal Reserve when double-digit inflation levels were registered in 1980. By end-1991, US inflation levels had come down to 3% and it mostly remained at these levels until now.

‘Good’ and Bad ‘Inflation’

Mild increases in inflation levels imply a positive economic climate. This scenario is typically witnessed when inflation leads to consumers expecting that prices will continue to rise. In a bid to save on future higher prices, users make more purchases in the present. There is enhanced demand over the short-term. This, in turn, leads to ramped up production levels and increased hiring to meet demand increases. Mild inflation levels, therefore, boost economic growth.

A second scenario where inflation is looked at optimistically is when it eliminates the threat of deflation. Deflation is when an overall fall in prices is observed. In a deflationary environment, consumers speculate whether prices will fall further, leading to reduced demand. Consequently, there is scaling back of production, workers are laid off and the business environment undergoes a slump.

The Great Depression of the 1920s saw prices fall by as much as 10%. And between 2006 and 2009, thousands of US homeowners saw the prices of their homes fall by up to 30%. They were ‘upside-down’ on their mortgages, meaning they owed more on their houses than the property was actually worth.

What is alarming is when inflation rates hit 10% or higher. Worse still is hyperinflation –  an economic scenario where price increases are as much as 50% in one month. In fact, prices for even essential commodities could fluctuate in the span of a few hours. A recent example of an economy that experienced hyperinflation is Venezuela; its consumers faced an astronomical 60,324% inflation rate in October 2018.

Inflation Will Persist

Inflation cannot be sidestepped; it is here to stay. But setting inflation targets could foster a sense of stability. In case of the US, its Federal Open Market Committee outlined an inflation level target of 2% over the long-term, since this figure was most conducive to ensuring optimum employment levels, and maintaining price stability. In doing so, the Board of Governors of the Federal Reserve System highlighted, “When households and businesses can reasonably expect inflation to remain low and stable, they are able to make sound decisions regarding saving, borrowing, and investment, which contributes to a well-functioning economy.”

Photo Caption: Inflation was, is and will remain a reality