Inflation Explained

When I studied in college, my parents would give me a monthly amount as pocket money. As is the want with most college going kids, that amount would never suffice because, firstly, it was definitely meagre and secondly, we had a lot of expenses as engineering students – getting the lab materials, printing the project reports, some amount for the canteen and several other miscellaneous expenses, often unplanned.(And to think of it, we didn’t have these kinds of expenses as today’s kids have like films in a mall or internet packs that bore a deeper hole in the pocket money.)

Every month when I would protest for a raise, my father had a pet peeve. He said his father would run the whole household in the same amount that I get as pocket money. Both of us knew the pun in the statement, for he would be referring to an era a good 50 years ago when even a 100 Rupees (a little more than a dollar today) would be enough to run a house for the whole month. Even gold could be purchased for half a dollarfor 10 grams. So you know how that worked. That’s the saga of inflation for the common man which turns even more complex when it comes to business and world economics.

When I started earning (finally!), my parents had just one advice for me: your income must always beat inflation. Which in effect, meant that if the country’s inflation is rising at a steady rate of say, 7%, your income cannot afford to rise below it. If it does, you end up devaluing your asset value. Your income must always surpass the country’s inflation so you save more even after spending more. So if a family allocates 20% of its income to household expenses, it must be able to increase income so much that it’s savings don’t eat into everyday living. That would cause a doom into its financial planning.

What is Inflation?

To put it succinctly, inflation is that which weighed in your grandpa’s pocket but somehow drained away as it reached you. It is the increase in the price of everyday commodities like food, clothing, fuel, metals, vehicles and so on. It measures an average price change in the cost in a basket of commodities and services over time. It denotes the fall in the purchasing power of a unit of currency of a country. In my case if you see, if in 1940, the same $2 would buy my grandpa 20 gms of gold, and some money to spare, the same $2 today would buy me a burger, at the most, when the cost of gold is skirting the $1000 mark or even more.

Economists say that some amount of inflation is good for the economy, otherwise the people would simply hoard the money in savings rather than spending it. And as anyone would understand, if people slow down on spending, who would buy the stuff produced in the market? Spending actually keeps the country’s economic engine well-oiled because it spurs more demand. As the value of the unit of currency (Ex. A dollar, or a Rupee or Pound) decreases over time, the things that it could purchase once get dearer and hence the cost of living of the people gets higher. That is why US President Ronald Reagan once said that “Inflation is as violent as a mugger, as frightening as an armed robber, and as deadly as a hit man.”

Measuring Inflation

All the countries in the world try and keep inflation at bay through a tough balancing act. The Central Banks of these countries are responsible to a large extent for that, it is also pertinent to see that too much deflation is not good for a country’s economic health. It’s the same when too much fat is not good for your body but it cannot afford to be too lean either. Every country has a department established to measure its inflation.  For example, in the US, the US Bureau of Labor Statistic (BLS) measures inflation by considering the Consumer Price Index. The Federal Reserve does not take into consideration the energy and food prices to calculate core inflation because these prices are too volatile to be included in the list. The Consumer Price Index (CPI) is compiled by the Department of Statistics (DOS) on a monthly basis in Singapore. What types of goods and services get included in the CPI and their respective weights are determined and updated once in five years. The Central Banks make use of this data to adjust policy changes that control inflation to maintain a healthy balance.

What Causes Inflation?

Several causes are attributed to why prices rise leading to inflation.

One of the main causes is when the supply of money in a market far exceeds the rate of economic growth.

Two main causes of inflation are:

1. Demand Pull: When demand for goods and services exceeds supply, cost increases. Ex. Just when the covid 19 pandemic began, most IT companies and educational institutions went online for their work. That resulted in a sudden huge demand for laptops in the market. So much so that laptops became scarce and people purchased whichever model was available at whatever price quoted. The laptop manufacturing companies did not get enough time beforehand to gear up for this unprecedented demand and hence prices of laptops increased by as much as 25 to 30% in a span of just a couple of months because sellers knew they could raise the prices and still sell, which doesn’t happen in a normal situation. When such a scenario arises for multiple sectors, the inflation rate goes up. In a sluggish economy, the govt. can also print more cash that results in inflation. However, this can be tricky, as in case of Venezuela that printed so much cash that it became useless after a while.

2. Cost Push:This type of inflation is caused when the demand is high but supply becomes low due to sudden unforeseen situations like natural disasters. It also happens when there is unusually high rise in wages or salaries giving rise to inflation. At times, when the govt. devalues its unit of currency, it makes buying locally far more lucrative than importing. That is a tactic used to encourage local buying and discourage import.

A classic case of demand pull inflation was the fall of the  Sushma Swaraj led BJP govt. in Delhi in India caused majorly by unusual short supply of onions and hence its sky high prices in 1998. A humble onion had become the reason for the fall of a national party govt. which has not able to regain the reigns of the state after that.

How is inflation controlled

Usually, it is the country’s central banks that play a key role in controlling spiraling inflation of a sustained duration. They do so mainly by increasing interest rates that puts a stop to easy money supply in the markets. When interest rates increase, people seek fewer loans and that buts a break in the surge in demand in the market.

Generally, inflation is adjusted in wages to employees of organized sectors, especially the government  sectors, through a hike in the dearness allowance payable to the employees. Also, several companies allocate a special Cost of Living allowance to its employees in certain areas where the cost of living is higher than that of other places. This ensures that all the employees of the company are at a level when it comes to earnings and expenses incurred by them.

How will the pandemic affect inflation around the world:

Certainly, in many ways.

For one, the lockdown imposed across the world brought the entire world to a standstill, halting production and disrupting all businesses for a long time. What happened last year during the April-May-June lockdown will have a long term impact on economies the world over. Millions of jobs were lost (mainly owing to companies shutting down, losing contracts, shuttering of allied businesses or simply because of no demand), that led to an unprecedented impact on the way people lived. Things that were earlier part of daily essentials no longer mattered.

The International Monetary Fund’s economic outlook for the world speaks volumes about the impact of Covid-induced inflation across the world. In several countries where business have remained shut for a longest period of time, the spike in the cases of infection in the second wave have seen excessive load on the country’s healthcare infrastructure that has crumbled in many parts. In India, for ex. Oxygen shortage has led to massive healthcare crisis in April 2021.

However, the only silver lining in an otherwise gloomy scenario is the vaccine that has come as a savior. All the countries in the world have had to dole out billions of dollars’ worth packages to salvage the economy. Free food, increase in hospital beds, subsidizing vaccine costs, boosting industries through tax holidays will definitely have long term impact on growth projections which have to be revised drastically.

The IMF pegs global growth rate at 6%, moderating it to 4.4% for 2022. A lot hinges on the strong economic packages offered by the governments, especially of strong economies, how the vaccination drive prevents further infections (or at least reduces severity of infections) and how the economy strengthens once things start normalizing (provided we don’t see a third wave pretty soon). The immediate impact of inflation in any country will not be visible because amidst lockdowns and mobility curbs in several regions, the demand for essentials is the only factor in play today.

In the days and months to come, the picture will be far clearer as to how each individual country embraces post lockdown and post-Covid19 recovery (if one can call it so, considering there is no immediate respite from the covid 19 virus effects that could last for a few more years, to say the least). Inflation is the result of the inability of a unit of currency to purchase the same goods that it did in the preceding time duration. But when there is little or no demand for certain goods, inflation would not be a possibility in the long term horizon. What will happen rather is a sluggish economy and countries would have to dole out packages to boost purchase all over again. The pandemic – induced lockdown had some surprises up its sleeves. While strong economies sailed through on the basis of massive economic packages, developing but robust markets saw a surprising low impact on inflation.

In most countries, inflation dipped for a few months during the lockdown and then surged back again, showing a kind of ‘V’ or ‘U’ shaped curve. It was only in Germany and Japan where some amount of deflation was seen. India has a different case altogether. 

Considering limited means of compiling data during the lockdown, low demand for products other than food (which has a strong bearing on CPI) and medicines, the rates of inflation may have to be seen with a tinted glass as of now until things get clearer. One reason for the relatively steady rate of inflation in most major economies is that while the production may have halted or reduced, the demand has also remained sluggish, thereby maintaining costs at almost stable levels. The people did not crowd to buy things that were non -essential, suddenly, once the lockdown was relaxed.

Inflation in developing economies would suffer a hit but that in the stronger economies would stabilize riding on the back of a high economic impetus provided by their governments as well as a resurgent economy aided by strong preventive measures for infection and a large-scale vaccination, lowering the covid graph further. Also, the fiscal spending hike as increased liquidity by these governments would aid a faster than normal recovery for them.

It is nations that are seeing massive surge in covid cases in the second wave that will suffer the most. With loss of livelihood, families in developing economies would be the hardest hit, leaving them with barely enough to buy food and medicine and hold on to any other kind of spending, at least in the immediate future. Even that money would be hard to come by if the second wave continues to spell doom, which means these countries would be staring at a malnutrition crisis that could have potential to spiral into health issues for many years to come. With most hospitals focusing (or having been forced to focus on) covid care, other health issues have taken a backseat for a long time. Experts have warned that escalating prices of food, fuel and other daily essentials could eat away into household savings, thereby further putting a spanner in spending in the days to come and causing a hindrance to economic recovery.

How does the world look in the future

(Source: https://www.imf.org/en/Publications/WEO/Issues/2021/03/23/world-economic-outlook-april-2021)

Above is the graph showing the April 27, 2021 World Economic outlook by the IMF whose projections show that while advanced economies shrunk by 4.7% in 2020, emerging economies, on the other hand, did fairly well, shrinking only about 2.2%. But the same will not remain in 2021 and 2022. That is mainly because advanced economies bolstered themselves through quick and disciplined measures, vaccination and huge dole outs by the governments and hence will fare much better, pegged at 5.1% this year and 3.7% for the next. The surprise is that the emerging economies are expected to outperform the advanced economies, riding heavily on a rising demand for goods and services in the unlock phase, inflation or no inflation. The large size of domestic markets in the emerging economies will also be a boon for them.

Disclaimer: This is just a depiction of my understanding of the financial concepts and this is in no way a financial advice.

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