What Are the Causes of Inflation?
US inflation eased slightly to 8.5% in July from 9.1% in June, but remains close to a 40-year high even as energy prices begin to cool. Consumers across the US and globe have seen prices rise sharply for a variety of goods and services, but what causes these prices to rise?
Inflation is one of the most contested issues facing economists and policymakers as the causes are varied, and the tools used to tame inflation have the potential to push the economy into a recession. Here is what you should know:
What is Inflation?
Inflation refers to an increase in the general price level of goods and services over time. Rising prices erodes purchasing power, meaning that the same dollar today will buy less in the future.
Inflation metrics are known as a lagging indicator, meaning they provide information on something that has already occurred. These statistics are used to confirm information, as opposed to forecasting.
You can use the BLS’s online inflation calculator to see how the value of the dollar has changed over time.
How is Inflation Measured?
The US Bureau of Labor Statistics (BLS) measures the inflation rate using the Consumer Price Index (CPI) and publishes the data monthly. This index is calculated using a survey of households and only covers spending on goods and services, excluding expenditures that aren’t paid for directly such as medical care. The basket of goods is maintained so the same goods are being measured each month.
Another way of measuring inflation is the personal consumption expenditures price index, or PCE, which takes into account a broader range of expenditures to provide a more holistic picture of price changes. This inflation metric is the Federal Reserve’s preferred measurement. The Commerce Department releases its PCE estimate monthly as part of its income and spending report.
What is Causing Inflation in 2022?
The current bout of inflation has several causes, many of which are linked back to the COVID-19 pandemic. First, consumers had a larger sum of money in savings from lowered interest rates, a decrease in discretionary spending on vacations/going out, and government stimulus programs. This increase in savings meant pent-up demand for goods and services flooded the system once COVID-19 restrictions were lifted, driving up prices for products and experiences.
Additionally, COVID-related lockdowns caused many supply-chain disruptions throughout 2021. In addition to the pandemic, Russia’s invasion of Ukraine also contributed to a run-up in many commodities prices including oil, wheat, corn, and precious metals due to shortages.
The added costs at every step of the supply chain, from production to sale, lead to price increases for consumers. According to the BLS July 2022 report, the CPI is up 8.5% from a year ago, down slightly from the June measurement of 9.1%.
Major Types of Inflation
Demand-pull inflation occurs when the demand for certain goods and services is greater than the economy’s ability to meet those demands. Demand outpacing supply puts an upward pressure on prices, which causes inflation.
Cost-push inflation occurs when the cost of wages and materials goes up. These costs are often passed down to consumers in the form of higher prices. Shortages or cost increases in labor, raw materials, and capital goods create cost-push inflation.
Causes of Inflation
Devaluation refers to a downward adjustment in a country’s exchange rate, resulting in lower values for a country’s currency. The devaluation of a currency makes a country’s exports less expensive, encouraging foreign countries to to buy more of the devalued goods.
Devaluation also makes foreign products for the devaluing country more expensive, which encourages citizens of the devaluing country to purchase domestic products over foreign imports.
Expansionary Monetary Policy
One main inflation theory is that central banks cause inflation by increasing the supply of money, which pushes down interest rates, making it easier for businesses and consumers to borrow money and spend more. As more businesses and consumers are spending, aggregate demand for goods and services will increase, causing prices to rise.
If the money supply increases faster than the rate of production, this could result in inflation, particularly demand-pull inflation because there will be too many dollars to be spent on too few of products. An increase in money supply is usually created by the Federal Reserve implementing expansionary monetary policy by purchasing bonds through open market operations (OMO).
Another tool for expansion is lowering the fed funds rate, which is the average interest rate banks charge each other to borrow funds. This action, in turn, lowers all interest rates, which allows borrowers to take out larger loans for the same cost. This dovish monetary policy prioritizes economic growth and maximum employment above maintaining stable prices.
It’s important to note that changes in fiscal or monetary policy are not guaranteed causes of inflation. Ultimately, demand-pull inflation results from a complex interplay of a variety of factors, and these policies are usually meant to interact with those factors to control inflation.
This worked fairly well to keep inflation at bay during the Great Recession, but did not work as well in response to Covid-19. This is likely due to the unique cost-push factors at play during the pandemic due to lockdowns.
Expansionary Fiscal Policy
Expanding the money supply can also create demand-pull inflation. When the money supply expands, it lowers the value of the dollar. When the dollar declines relative to the value of foreign currencies, the prices of imports rise. That increases prices in the general economy.
The money supply can increase through expansionary fiscal policy, which is enacted by the federal government. These policies expand the money supply by pumping money into certain segments of the economy, creating demand-pull inflation in those areas.
The government stimulus programs enacted during the Covid-19 pandemic are good examples of expansionary fiscal and monetary policy. As inflation began to rise in 2021 and 2022, many economists agreed that these expansionary policies, which put a significant amount of cash in Americans pockets, had played at least a partial role in driving up prices.
A disruption in supply, such as a natural disaster, freak accident, or global pandemic, can reduce overall supply temporarily and lead to inflation. By increasing production costs, as long as demand remains constant businesses will either have to pass the costs through to the prices of goods, or accept a lower profit margin.
Wage-push inflation is an economic theory that states inflation occurs due to rising wages. Wage-push inflation claims that higher wages force businesses to raise the price of their final goods or deal with lower profit margins from the increased cost of labor.
Economists are generally divided when it comes to the impact of wage growth. Some believe that even a steady rise in wages will cause inflation to speed up, while other believe only that rapid increases in wages, as we’ve seen in the tech industry, causes cost-push inflation due to the higher cost to do business.
Other economists believe that higher wages across the board would increase demand enough to offset a spike in prices. In this case, rising wages allow consumers to pay higher prices without impacting their purchasing power.
How Central Banks Manage Inflation
Central banks around the globe use monetary policy to avoid inflation as well as deflation (and even stagflation). In the US, the Federal Reserve has a target inflation rate of 2% annually.
The Fed uses the core inflation rate, which excludes the highly volatile energy and food prices. In response to high inflation, the Fed can implement hawkish monetary policy including reducing the supply of money and raising interest rates in an effort of quantitative tightening.
By raising the fed funds rate, the Fed influences all interest rates in the country including mortgages and credit cards. Higher interest rates make it more expensive to borrow money, which tends to slow the economy down as people focus on savings rather than spending.
A slower economy forces businesses to maintain price levels in order to keep customers. This should eventually slow inflation by tamping down on economic activity.
In 2020, the FOMC announced that it will allow an inflation target of more than 2% if that would help ensure maximum employment. In March 2022, the FOMC began responding to higher inflation by raising the fed funds rate for the first time since 2018.
Help Protect Your Personal Finances From Inflation
Inflation makes purchases and investments more expensive by decreasing your purchasing power as prices rise. There are a few common methods to help protect your investment accounts and savings accounts from a higher cost of living.
High-Yield Savings Accounts
Keeping cash in a checking account can feel the safest because it is the most easily accessible, but as the rate of inflation increases, the value of your cash is eroding.
Instead, a high-yield savings account that offers a higher annual percentage yield (APY) may provide more protection, while preserving your liquidity. The interest rates of savings accounts, CDs and similar vehicles also rise with the fed funds rate.
Diversified Investment Portfolios
Diversifying an investment portfolio with stocks, bonds, and alternative assets can help potentially minimize losses if one investment doesn’t perform well. There are many investments that can act as inflation hedges, meant to protect your portfolio from diminishing purchasing power. There are even some industries and assets that benefit from rising prices.
This material is provided for informational and educational purposes only. It is not intended to be investment advice and should not be relied on to form the basis of an investment decision.