Inflation: causes, effects and how to deal with it

1. What is inflation?

Inflation is a general increase in the prices of goods (e.g. food, electricity and fuel) and services (e.g. haircuts and train tickets).

Inflation does not refer to the price of just a few products, but rather to many goods and services.

The increase in prices reduces the amount of goods or services we can purchase with the same amount of money: this is why we say that inflation reduces the value of money over time.

Today's €100 are not the same as tomorrow's €100

Mario is a restaurant owner and has a daily €100 budget for purchasing bread. Bread costs €4 per kg, so Mario can buy 25 kg of bread. Now let's imagine that the price of bread increases to €5 per kg, due to inflation: with the same €100 banknote, Mario can now only buy 20 kg of bread. Because of inflation, the banknote's actual 'value' is now just 20 kg of bread, whereas before the rise in prices, its value in bread was 25 kg.

Economists call the banknote's €100 its nominal (or face) value, whereas the amount of goods or services that can be purchased with it - in our case, bread - represents the banknote's real value. In our example, the banknote's nominal value remains the same after the increase in the price of bread, but its real value decreases from 25 to 20 kg of bread, due to inflation. In other words, the €100 are worth less, and they have lost purchasing power due to the rise in prices.

Speaking of bread and other essential food necessities, one of the most striking instances of inflation, or rather, of hyperinflation, is that of the Weimar Republic (Germany, autumn1923): the value of the mark (the German currency of the time) dropped so low that in order to shop for groceries, people had to carry banknotes around in handcarts.

The opposite of inflation, which is a general decrease in prices, is called deflation.

High levels of inflation or deflation are detrimental both for citizens and for the economy as a whole: indeed, price stability, i.e. stable and predictable inflation, is one of the indicators of a happy economy.

2. How to measure inflation

Let's make this clear: measuring inflation is not simple, as inflation is a general increase in prices, which refers to a large number of goods and services that represent households' spending behaviours.

This is why inflation is measured with a consumer price index, an average of the prices of a set number of goods and services called a basket, which is the Italians' shopping cart! The average is weighted by taking into account the varying degrees of importance of the goods and services in the total amount we pay. Variations in the index correspond to a generalized variation in prices, which means inflation (if there is an increase) or deflation (if there is a decrease).

If we read that, in November 2022, the inflation rate in Italy was 12.5 per cent on an annual basis, that means that between November 2021 and November 2022, the average of the prices of the goods and services in the basket increased by 12.5 per cent.

The Italians shopping cart

The price basket tells us a great deal about our past, as it is regularly updated to reflect Italians' consumer habits.

The Italian basket was created in 1928 and originally consisted of 59 items, mostly groceries. This basket, which remained in place until 1938, also included firewood for heating and cooking, which stayed in the basket until 1966, although it became less and less important. In 1986, notepaper was first included, only to be removed after just a decade; mobile phones were added to the basket in 1996, and internet subscriptions in 1999, whereas public telephony services were definitively removed in 2018.

The basket has been updated on a yearly basis since 1999. Today, it includes a total of 1,772 goods and services, divided into twelve groups. New entries for 2022 included office chairs, air fryers, COVID-19 swabs and psychotherapy; compact discs, on the other hand, were definitively removed. Aesthetic treatments for men have also been monitored since 2020.

In Italy, the National Institute of Statistics (ISTAT) is tasked with keeping the basket up to date, assessing the price indices and calculating inflation on a monthly basis.

ISTAT produces three different indices: the Consumer price Index for the whole Nation (NIC); the Consumer price index for blue and white-collar worker households (FOI) and the Harmonized Index of Consumer Prices (HICP). The reason why three different indices are needed is that inflation is not the same for everyone, as it depends on different households' spending behaviours. Therefore, statistics institutes produce different indices for different categories of people. The harmonized index, on the other hand, is produced in order to aggregate and compare the data on Italian inflation with those of other euro-area countries.

Finally, there are consumer price indices based on baskets that exclude specific goods and services whose prices show significant fluctuations. These are typically groceries - whose prices are affected by the climate, as well as energy products, such as petrol and diesel oil. The inflation rate that is calculated through indices that don't take into account such products is called core inflation, and can provide economists with extremely useful information for distinguishing between sporadic changes in the prices of certain goods, and a more generalized price increase or decrease.

3. The causes of inflation

When the demand for a good or service increases beyond their supply, their price increases (people are willing to pay more to buy what they need). If we apply this principle to the entire ISTAT basket, a rise in consumer demand can lead to inflation. This is the case with demand-pull inflation: a period in which consumer demand for goods and services is higher than the quantity supplied by the market.

Demand-pull inflation at the greengrocer's

In order to better understand the relationship between demand, supply and prices, let's picture a small greengrocer's in an old neighborhood, which only has one apple counter. Let's imagine that a large residential building block is erected not far from the market. The number of clients for the market will double in a short period of time and, when autumn comes, many more people will go to the market to buy apples.

The immediate effect is that our apple-seller will have people queueing at their counter, and will therefore be able to take advantage of owning the only apple counter and raise the prices.

However, in time, news will spread that there is good money in apples, and new sellers will arrive, whether in the same market or nearby, offering apples at increasingly lower prices in order to attract new clients. The increase in apple supply will drive down prices until a new supply/demand equilibrium is reached.

Excess demand over supply of a good can sometimes be caused by a sudden decline in production. A rise in prices can also occur due to an increase in production costs.

This is the case with supply-push (or cost-push) inflation: the demand for goods and services doesn't change, but either production capacity decreases or its costs increase. This can be caused by different factors, such as an unexpected event that impedes the provision and production of goods (e.g. a pandemic or a war), or an increase in the costs of raw materials, such as oil.

Supply-push inflation, still at the greengrocer's

Back at our apple market, let's imagine there is a surge in the costs of fertilizers and diesel oil. This makes growing apples and carrying them to the market more expensive. The market apple-sellers will react by charging their clients higher prices.

Let's now hypothesize/imagine a different scenario, an unexpected event such as a pandemic or a drivers' strike, which impedes the provision of apples: only half as many apples will be produced, which will generate a new imbalance between supply and the demand from households, who are now used to having three counters full of apples, so the price of apples will increase.

Sometimes high inflation may be due to a number of factors, relating to both supply and demand. For instance, the sharp increase in prices in the US during the post-pandemic economic recovery (2021-2022) can be explained both by the rise in demand (people started going out and spending, partly thanks to the government subsidies received during lockdown), and by the fall in supply due to businesses closing, which impeded the production and transport of goods all over the world.

Finally, long-term inflation can be caused by the amount of money in circulation exceeding the value of goods and services: too many euros chasing too few goods!

4. Why should we start worrying when prices rise excessively?

The effects of inflation...

High inflation makes it difficult to accurately evaluate the changes in relative prices on which households and firms base their consumption and investment decisions. It randomly makes people richer or poorer, depending on the condition in which they happen to find themselves when inflation strikes. It increases interest rates, thus making investments more expensive, and in the long term, it correlates to poor economic growth: we will all be sharing a smaller pie.

...on savings

Inflation hits the savings we have built up over time and decreases their value and purchasing power: we can't buy as many goods and services with the same money. Our earnings' real value will also fall, unless they are increased to match inflation.

Escalator or quicksand?

If my (nominal) wage increases by 5 per cent (for instance, from €30,000 to €31,500) in a year, and inflation grows by 9 per cent, my purchasing power decreases by 4 per cent (+ 5% - 9% = - 4%). The €31,500 euros I have today will allow me to buy the same amount of goods and services as €28,800 euros would have last year.

For many years, a mechanism called an escalator was in place in Italy: wages used to be index-linked to inflation, that is, they used to rise automatically to match the rising prices. This mechanism was introduced in 1945 and was also used in other countries; however, it was weakened in the 1980s and finally abolished in the early 1990s for a simple reason: automatic wage rises fed into future inflation by increasing costs for businesses, thus raising the prices of goods and services. This is known as a wage-price spiral, which, once it has started, becomes extremely difficult to stop and can generate very high levels of inflation. Escalator or quicksand?

In times of high inflation, there is another factor that erodes our earnings even when they increase with the prices: higher nominal wages are subject to higher taxation. Therefore, we pay more income tax, which means that even if the real value of our gross income is unchanged, thanks to the increase to match inflation, our real net income is lower. This is known as 'fiscal drag'.

...on loans

It isn't just earnings and savings whose real value decreases due to inflation, but also loans. Those who have taken out a fixed-rate loan, and who are therefore repaying it in fixed monthly instalments, benefit from inflation, as it reduces the real value of the money owed; in addition, the amount of each instalment remains unchanged, whereas our earnings will sooner or later increase with inflation.

For variable-rate mortgages, on the other hand, the effects of inflation are less significant, and potentially detrimental. That is because inflation usually correlates with increased interest rates, which in turn cause a rise in the amount to be paid for each instalment, so the real value of the money owed does not change (in fact, if our earnings don't increase immediately alongside inflation, we may find ourselves poorer, at least for a short while).

Finally, for those who are about to take out a loan, whether variable- or fixed-rate, an increase in inflation and interest rates leads to increased borrowing costs (and in the case of mortgages, in higher amounts for each instalment).

In short, we might say that inflation isn't a problem for those who have already taken out a fixed-rate loan, whereas it is usually a disadvantage for those who are going to take out a loan.

The Government is the biggest debtor. Every year it issues bonds in order to borrow billions of euros to cover the difference between revenues (tax and levies) and expenses (public spending on education, defense, healthcare, pensions and so on), as well as to pay back the bonds that have reached maturity. Therefore, as far as fixed-rate public debt is concerned, inflation benefits the Government as it reduces the real value of the loan to be paid back.

Nevertheless, inflation can be detrimental for the Government too in the long run: for instance, public expenses such as pensions, goods and services, and interest on debt will increase.

...and on financial investments

As far as our financial investments are concerned, the situation is reversed: for every debtor who benefits from inflation (as is the case for fixed-rate loans), there is a creditor who loses money, and the other way round!

Therefore, those who purchased a fixed-rate bond, thus becoming creditors of the Government or of a firm, will be penalized by inflation. As interest rates rise, the price of their bond will fall to reflect the smaller real value that the coupons and the principal will have at maturity. On the other hand, those who have invested in variable-rate bonds, which are indexed-linked to inflation or market rates, will be protected if inflation rises: the increased value of the coupons or the principal paid back at maturity will compensate - completely, or in part - the loss of the purchasing power of money caused by inflation.

The increase in interest rates brought about by inflation may also reduce the value of other investments, such as stocks (but investment in real estate is not protected either). In this case, the correlation between interest rates and the value of such assets may be complex: we have explored it in detail in this article.

Finally, here is one last way that the situation is reversed compared with that of debtors: those who decide to invest part of their savings, but haven't done so yet, will find a greater earnings potential than before, due to the higher interest rates correlated to inflation.

Inflation is an unjust tax

Inflation is said to be 'an unjust tax', so let's see why. First of all, it is called a tax because it reduces the amount of goods and services that people can buy, but most importantly, it is unjust because it does not affect everyone to the same degree.

Typically, inflation hits the less well-off the hardest, as those who are worse off use up a larger share of their income to purchase the bare necessities (groceries, energy and transportation), which are often subject to the greatest increases. Generally speaking, the increased cost of living could make it impossible for income to cover basic expenses, forcing those who are worse off to dip into their savings (provided they have any).

5. Why worry even when prices drop?

If inflation can be dangerous, the opposite, that is the generalized fall in prices known as deflation, can also damage the people and the economy of a country: consumers may decide to postpone their purchases while waiting for prices to decrease; household spending will decrease and, consequently, businesses may cut back on their investments and employees, setting off a chain reaction which affects consumption and the economy as a whole (a deflationary spiral).

Contrary to inflation, deflation may lead to an increase in the purchasing power of our income and savings in the short term; on the other hand, debtors will be penalized by the fall in prices, because the money they owe will have a higher real value. In the long term, wages will fall, or maybe even disappear due to job loss or decreased turnover!

Deflation and the lost decade

One of the most famous instances of deflation was in Japan from the early 1990s to the early 2000s.

A number of factors - including a period of crisis for the main Asian economies, as well as a drop in Japanese real estate value - contributed to Japan experiencing a prolonged period of internal demand stagnation; demand increased slightly some years, in other years it decreased and this led to general price stagnation.

We talk about the lost decade because Japanese citizens, who expected prices to keep decreasing, postponed their purchases, thus creating problems for businesses, which were forced to downsize their employees. Deflation is a conundrum/strange thing: even when the Japanese economy bounced back, the prices of some categories of goods, such as clothing, kept decreasing.

6. Who protects us against inflation

If both high inflation and deflation are detrimental to citizens, it is easy to see that the ideal scenario for the economy is low, stable and predictable inflation. So how can we make sure that is the case? Who is in charge?

The answer is central banks, which are tasked with keeping inflation and deflation in check, and maintaining price stability through their monetary policy.

Inflation, central banks and monetary policy: disease, the physician and medication

If excessively high levels of inflation or deflation are a disease for our economy, the central bank is the physician we turn to, and monetary policy is the medicine which provides the therapy.

The European Central Bank (ECB) has set an inflation target of 2 per cent over the medium term. Our physician treats inflation as if it were blood pressure: if the pressure is too high, it must be lowered to prevent the risk of a heart attack; on the other hand, if the pressure is too low, the patient will not be able to get out of bed. Both situations - too high or too low a pressure - must be avoided, as is the case with high inflation and deflation.

Monetary policy works as a drug or a supplement that helps regulate blood pressure.

Through monetary policy, a central bank makes decisions that influence the cost and availability of money in an economy. It normally does so by using specific instruments, known as 'key interest rates'. By raising these rates, the central bank seeks to influence all other interest rates, including those applied by commercial banks to medium- and long-term loans to their customers. This makes borrowing money less affordable, as mortgages and other loans are more expensive. Furthermore, people will save more, as interest rates rise on money kept in accounts and other saving instruments. Therefore, household spending and business investments decrease. There is a decline in demand, and consequently, in price growth. An increase in interest rates can also influence consumer and business expectations about future inflation (inflation expectations).

Conversely, if inflation is too low or there is deflation, the central bank reduces interest rates to foster consumer and business demand and help the prices of goods and services grow.

An effective drug for the treatment of inflation? Raising interest rates!

There is an inverse relationship between the increase in interest rates and the inflation rate. An increase in interest rates hinders demand and economic growth and may lead to a rise in unemployment (the drug's side effects), whereas a decrease in interest rates furthers growth in demand, in the economy and in employment. Demand will exceed supply and then prices will rise. Although there are many ways in which interest rates can affect inflation (transmission mechanism) and some of them have uncertain outcomes, raising interest rates is the main monetary policy instrument when it comes to containing inflation. Conversely, decreasing interest rates is the tool used to foster demand and economic growth and generally to increase prices. When interest rates are raised, we talk about restrictive monetary policy and when rates are lowered, we talk about expansionary monetary policy.

Although the main instrument of monetary policy is altering interest rates, central banks have more recently implemented a new measure that directly affects financial markets. By buying and selling bonds, a central bank can influence the trend of longer-term interest rates. It is the same principle: higher rates cool the economy and therefore inflation, and lower rates stimulate the economy and bring inflation back up to the desired level.

7. What to do in the event of high inflation

  1. Good financial planning is essential, starting with keeping a budget, which is a record of revenues and expenses. Only if we are aware of how we spend our money on a daily basis can we know what we can do without, if need be, and how to save in periods of financial difficulty and uncertainty. Planning helps us understand how essential expenses that we cannot avoid (heating, bare necessities and so on) may vary, as well as what non-essential expenses can be cut out (lifestyle expenses). Once we have divided our expenses into categories, we need to increase our emergency fund, bearing in mind that in the event of high inflation, unexpected expenses may arise and threaten the balance of our revenues and expenses.
  2. Making informed choices is even more crucial, which you can do by comparing different offers on the market before making a purchase, and before going to the bank to take out a loan or open a bank account: the Bank of Italy Guides can help you with this.
  3. If we have savings, the first piece of advice to protect them from inflation is to diversify, that is to invest in several different financial products (deposits, Government securities, shares and bonds and so on). As well as being a good rule of thumb for any wise investor, diversification is useful for countering the negative effects of unexpected rises in inflation! Specifically, when inflation increases, interest rates and yields on financial assets tend to increase too: it is therefore important to invest part of our savings in short-term financial instruments, or in variable-rate instruments, whose returns adapt quickly to match the increasing rates (for instance, current accounts and short-term deposits, BOTs, Government securities and other variable-rate or inflation-indexed bonds, such as BTP€i or BTP Italia and so on)
  4. If we need to get into debt, for instance by taking out a mortgage or a loan, we have to bear in mind that a fixed rate may be higher than a variable rate in the short term, but in the long run, a fixed-rate loan ensures that the borrower pays a fixed-amount instalment - thus protecting us against inflation - whereas the instalment amount of a variable-rate mortgage grows with the interest rates. In such cases as these, good financial planning becomes even more important to keep track of expenses and future instalment payments so that we can understand if we can afford them.

Generally speaking, when prices are rising, cultivating financial literacy becomes especially important in order to make informed choices as consumers, savers and investors.

You'll be able to find lots of useful information on this website!

References

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