One of the most popular buzzwords in financial markets at the moment is inflation. Just about every country across the globe is reeling under the impact of high inflation. Be it the United States, Turkey and even here in New Zealand, where inflation has hit 7.3%, the highest in over three decades.
When people talk about inflation, the first thing that comes to mind is higher prices, from everyday goods to transportation and just about everything else. But what is inflation, and how does it impact prices?
And, importantly, what are the consequences of higher inflation on an economy? In this article, we look into inflation and consumer prices. We also explore the driving factors behind current inflation, and what central banks are doing to contain inflation across the world. But first, let’s get started with the basics.
What is inflation?
Inflation is an increase in the price of goods and services in an economy. Inflation measures the increase in these prices and is represented in percentage terms.
If a loaf of bread cost $5 last month, but now costs $5.50, this is an example of 10% inflation, albeit for just one item. It now costs more to buy a loaf of bread than it did one month ago. Thus, the consumer’s purchasing power has been reduced.
Here in New Zealand, the rate of inflation is measured by the Consumer Price Index (CPI).
What is the Consumer Price Index?
The CPI is a measure of inflation used across the world. It tracks the price changes of a set basket of goods and services. The way CPIs are calculated, and the goods and services measured, tend to vary country to country.
For example, in the US, the CPI index is calibrated to 100 and is tracked on a monthly basis. Thus, an increase in CPI to 125, means that consumer prices have risen 25% on a month-on-month basis.
The most common period measure is a quarterly period, although some economies such as the Eurozone also release consumer prices on a monthly basis. The quarterly period is then annualised and compared to the same period the previous year.
Therefore, when you read a headline that states, “New Zealand inflation touched 7.3% in the June 2022 quarter” it means that consumer prices rose 7.3% compared to the same period in 2021.
CPI is one of the most common measures of inflation, but there are others. Traders are familiar with another aspect of CPI called the Core CPI. The Core CPI excludes volatile items such as food and energy prices. Because of this distinction, core CPI tends to be less reactive than the main or headline CPI.
Another measure of inflation is the Producer Price Index (PPI). This is referred to as “factory gate inflation” and is a measure of the general increase in the cost of goods and services used for manufacturing. These items are quite different from the items found in the consumer price index.
The purpose of the PPI is to measure the cost of goods production. It can include household appliances, such as televisions, refrigerators and cars, to heavy industrial machinery. An increase in prices for raw materials usually results in increased costs for manufactured goods.
Because many manufactured goods are exported, the PPI can have an effect on a country’s balance of trade. Higher domestic manufacturing prices can lead to lower price-competitiveness on world markets.
Together, the CPI and PPI give a general overview of the costs of the goods and services produced and purchased in an economy.
The link between inflation and GDP
Connecting the dots, it’s easy to see why inflation matters. When things get more expensive to buy, people tend to cut back on spending. This in turn leads to lower economic activity. Lower economic activity leads to reduced business expansion and thus the hiring cycle.
Therefore, central banks usually try to keep inflation stable. Many major central banks, including the Reserve Bank of New Zealand (RBNZ), maintain a dual mandate. The RBNZ’s dual mandate is to promote price stability and support maximum sustainable employment.
However, the dual mandate’s focus on employment does limit the RBNZ’s power to implement its monetary policy tools, especially during times of high inflation or recession.
What influences inflation or consumer prices?
By now you may be wondering what causes inflation rates and prices to spike. And while there are a number of reasons. Perhaps, at present in New Zealand, the biggest factor is the hangover from the pandemic’s ultra-low interest rates and freely available money. Add to that supply chain issues and war in Europe, and you’ve the perfect recipe for pain at the check-out and pump:
Excess money circulation
When there is lots of money in circulation, there’s plenty to go around, which can spur consumers to spend more.
The current example of this is the RBNZ’s stimulus policy in the face of the Covid-19 pandemic. Its interest rate cuts and quantitative easing, which were designed to stoke the economy, also led to a housing bubble, and rampant house price inflation.
In short: too much extra money sloshing around an economy can quickly lead to higher prices as demand for goods and services grow.
Lower interest rates
As highlighted in the above example, lower interest rates can have a big effect on inflation. Lower interest rates help businesses and consumers to borrow more. The borrowing is usually spent on business expansion or, in the mortgage markets, on spending more on houses.
Lower interest rates spur economic activity, but if not managed can lead to inflationary pressures.
Oil and energy prices
Crude oil, and hydrocarbons remain the lifeblood of the global economy. Whether you want to ship products from one part of the world to another, or transport goods from a warehouse to a retail store, fuel is needed.
Thus, oil prices are crucial and play a significant role in the context of inflation. Higher fuel prices automatically raise the costs of transported goods. This in turn is reflected by retail prices.
The above chart compares the US inflation rate to spot crude oil prices.
You can see how higher oil prices during normal economic conditions tend to push consumer prices higher as well. As of 2021, we can see a strong surge in oil prices with inflation moving in the same direction.
The US dollar
The US dollar is the world’s reserve currency. Much of global trade is settled in USD. Therefore a stable USD is required in order to keep prices of commodities steady. When the US dollar appreciates across the board, countries that import commodities need to spend more.
Thus, the more expensive the dollar gets, the more the costs of imported goods increase. This can be a major issue for economies heavily reliant on imports. Take, for example, crude oil, which is settled in USD.
The US dollar is a free-floating currency, and its value is set by market dynamics. During times of global crises, the US dollar is a safe haven.
As you can see from the below chart, the dollar appreciated both at the start of the Covid-19 pandemic, and when Russia invaded Ukraine.
When investors pile on to the global safe haven status of the greenback, it can cause inflationary pressures on economies around the world.
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