What is inflation, and why is it so high?

As 2021 draws to a close, global inflation levels continue to rise. What is inflation, why is it high, and why is it a concern?
Conjointly Guide to Inflation
Consumer health and economic impact concerns

As 2021 comes to an end, inflation continues to rise in nearly all major economies. In October, the US Bureau of Labor Statistics announced the 12-month inflation rate was at the highest point since 1990 at 6.2 percent 1. Meanwhile, in the UK, the inflation rate hit a 10-year high of 4.2 percent 2, while inflation surged to 4.1 percent in the Euro area 3.

In each of these economies, the current inflation rates are considerably higher than the target set by their central banks of 2%. At the same time, economists and analysts express divided stances on whether inflation will continue to rise or return to pre-pandemic levels 4 5 6.

This first part of Conjointly’s Guide to Inflation defines what inflation is, explores why it is currently sitting at levels not seen in the last 20 years and why it is a concern.

What is inflation?

In the simplest terms, inflation is a rise in overall price levels 1. In economics, inflation is an estimate of the rate at which the decline in purchasing power occurs can be reflected in the increase of an average price level of a basket of selected goods and services 2. Deflation is the opposite – an estimate of the rate at which the purchasing power increases and price declines.

Inflation is a highly debated phenomenon as its impacts can be viewed either positively or negatively depending on the context 7 8. It is generally recognised that moderate inflation benefits the overall economy. Central banks of developed economies, including the US, the UK, and the Eurozone, typically set a long-run target for the annual inflation rate at 2% 1 2 3. This goal is based on the central tenet that a slowly increasing price level keeps businesses profitable and prevents consumers from waiting for lower prices before making purchases 9. However, when inflation rises above target levels and begins to act unpredictably, issues arise.

How did we arrive at such high inflation?

Typically, inflation is the result of both supply-side (also known as cost-push inflation) and demand-side issues (also known as demand-pull inflation) 10 11. Economists have also identified a scenario known as built-in inflation, a vicious cycle of rising living costs that result in expectations for higher wages, which eventually leads to increased production costs and even higher prices.

The outbreak of the COVID-19 pandemic has been heavily influencing the current period of inflation. Therefore, understanding the following sequence of events is crucial to better understand the current inflation levels.

1. The COVID-19 pandemic

The first human transmission of COVID-19 was confirmed in January 2020 in Wuhan, China 12. Many countries in Asia, Europe, North America, and Africa started to report confirmed cases in the same month. In March 2020, the World Health Organisation categorised the disease as coronavirus disease (COVID-19), which was then declared a pandemic 13 14.

Most European and North American countries began to see a massive spike in cases starting April 2020 15. To combat the pandemic, governments introduced and implemented quarantine rules, curfews, and border closures, which many call the Great Lockdown era 1216, keeping many workers away from their job 17. As a result, factories, manufacturing plants, logistics and deliveries were disrupted, leading to disruptions in supply chains. This disruption in supply quickly resulted in a general price increase across many economies 18 19.

On the demand end, the Great Lockdown confined people to their homes 20 and prevented them from consuming. As a result, consumer demand for many products and services dropped, putting downward pressure on inflation 21. Altogether, some economies observed deflation and the beginning of a recession 21.

2. Government stimulus packages

To shield economies from the damages of the containment measures, governments began to introduce expansionary fiscal policies and stimulus packages 22. For instance, the US Coronavirus Aid, Relief, and Economic Security Act (CARES Act) provided over $2.2 trillion in stimulus to small businesses and lower to middle-income households 23. Central banks also provided low to zero interest rates to stimulate more investment and spending 24.

Both the stimulus packages and reduction in interest rates raised the supply and lowered the value of money, thus driving inflation. This trade-off between inflation and expansionary fiscal policies was based on the expectation that both the supply and demand would quickly return to normal as the lockdown would be lifted in a short period of time 24.

3. Easing of lockdown and recovery begins

The roll-out of COVID-19 testing kits and vaccine programs allowed countries to ease COVID-19 restrictions 25 26. As a result, many countries have seen demand recover and revised economic projections for 2022 27. Inflation also started to pick up from deflation and recovered to the pre-pandemic level. However, inflation is rampant and lingers above the central banks’ target.

Why is this inflation wave concerning?

A core goal of economic policies is to maintain economic stability, enabling businesses and consumers to carry out their planning and activities 22.

In normal situations, any issues on supply or demand will be taken care of by the economic system itself 24. However, the unprecedented COVID-19 pandemic has made this economic crisis unique.

1. Uncertainty threatens aggregate demand

Recent research has found differences in inflation expectations among households during the pandemic. There are an increasing number of households with deflationary expectations and a simultaneously increasing number of households with high inflation expectations 28.

Households disagreement between inflation and deflation expectation

The different expectations may eventually lead to a massive difference in consumption attitude and behaviour. Furthermore, households increased their precautionary savings due to inflation uncertainty 28. Altogether, the government stimulus packages may not be as effective as initially thought, and economies may take longer than initially expected to return to the pre-COVID level.

When inflation is rising at an unstable rate and acting unpredictably, prices become unreliable and vague in the eyes of consumers and businesses. In other words, consumers may not rely on price to evaluate products and services. This adds difficulties to forecasting demand.

2. Current inflation run is much higher than the initial expectation

The US and UK central banks expected inflation to peak in August 2021 29 30. However, inflation has continued to rise 5. If governments need to intervene, there are ongoing debates on whether current inflation is due to the increase in aggregate demand or supply 10 11 21. Both scenarios require different policies to stabilise the price without jeopardising the ongoing recovery 21. For businesses and consumers, this means the inflation can still go either direction and makes planning difficult.

3. No quick fix for supply disruption and cost-push inflation

On the supply side, the uneven easing of lockdown among regions is a primary source of disruptions. Low vaccinated regions continue to face the economic and social costs of lockdown 31. As these regions make up part of the global supply chain, supply disruptions will remain until the impacted businesses secure alternatives.

For countries that exited lockdowns, the pandemic still poses health risks and concerns among citizens 32. Rising living costs and health concerns have triggered the Great Resignation in the US, Europe and Asia, which see millions of workers leaving the workforce, adding more misery to supply disruptions 33.

Coupled with congested shipping routes, piling-up containers in ports, and soaring energy prices 34, the cost-push inflation is unavoidable, and there is no short-term remedy.

How does inflation impact different businesses?

The impact of inflation is unique to each business, sector, and industry. Next, we look at how it varies and the value and limitations of inflation data.


References

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Written on 9 December 2021 by:
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Chun Hui Lee
Insights Writer