A beginner’s guide to inflation
One of the most frequently mentioned topics in the financial news is inflation. But what exactly is it and how does it affect the economy? Matthew Partridge explains the basics of inflation.
One of the most frequently mentioned topics in the financial news is inflation. Almost every day someone pops up claiming that money printing will turn us into another Zimbabwe. Others claim that unless the central bank takes action, there is a very real chance of deflation.
However, just what is 'inflation' and how is it measured? Is it always a bad thing or is a small amount necessary? We've put together this short beginner's guide to give you a gentle introduction to the topic.
What is inflation anyway?
There are various ways to look at inflation. But the simplest definition and what most people understand inflation to mean - is that it's a rise in the overall level of prices for the goods and services consumed by households.
The key word here is 'overall'. Most people buy a wide range of goods and services every day, which rise and fall by different amounts. Price changes in some of these goods, such as food and electricity, are more visible than others.
Also, people do not buy exactly the same things: a teenager's shopping basket will be very different to a pensioner's. So different groups of people will be affected differently by any given price change.
You can already see that there's some room for debate over how inflation should be measured. But in an attempt to get some broad idea of how the cost of living is changing, the Office for National Statistics puts together an index based on a basket of goods and services consumed by the average person.
To ensure that the index reflects what people are actually buying, and that the changes in prices are correct, a large number of price and spending surveys are carried out, and the baskets are regularly updated.
In the UK, the two major indices are the Consumer Prices Index (CPI) and the older Retail Prices Index (RPI). Most other countries simply use a CPI-type calculation (also called the Harmonised Index of Consumer Prices in the rest of the EU).
What's the different between RPI and CPI?
The main difference between these two inflation measures is that the RPI includes housing costs (through mortgage payments), whereas the CPI does not. This means that RPI inflation is usually (though not always) higher than CPI inflation. Indeed, between 1996 and 2011, RPI went up by 54% while CPI only rose by 36%.
While critics argue that the CPI understates inflation by leaving out housing costs, its supporters argue that housing is an asset rather than a good, and should therefore not be counted. They also argue that since many mortgages are variable rate, a hike in the interest rate in order to cool the economy (and bring inflation down) would actually end up raising inflation (because it would push up the monthly mortgage payment, which is included in RPI).
The two methods are calculated using slightly different formulae. RPI is calculated arithmetically, while CPI is calculated geometrically.
The latter methodology takes account of the tendency of the consumption of goods to change when prices go up. This should have a relatively small impact, as it does in other countries.
However, due to quirks in the way that clothing and footwear prices are calculated, the difference is much greater. Indeed, experts have found that the two categories account for nearly two-thirds of the gap between CPI and RPI.
Governments, noting this gap, have become ever more keen to use CPI in the updating of tax and benefit banks. In June 2010, for example, the government switched from using RPI to using CPI to update public sector pensions. It has also talked about allowing firms to make a similar switch for their pensions.
Cynics argue that this and similar measures to reform how CPI is calculated in the US are nothing more than a way to disguise pension cuts and tax increases.
Other problems with measuring inflation
There are also a few other minor issues with inflation measures. For instance, some experts argue that the price of energy and food is so volatile that it doesn't make any sense to include those in the basket. The resulting index is called the 'core CPI'. However, others point out that it makes little sense to exclude major items of spending from price calculations, regardless of how volatile they are.
Another ongoing debate is over how to properly measure changes in the quality of goods over time. For example, £1,000 will buy you a far better laptop this year than it would have a decade ago. While most people agree that some adjustments need to be made to account for the improvement in quality, some argue that the methods used (known as hedonic adjustment') go too far.
Finally, there are allegations that some countries, most notably China and Argentina, lie about inflation. Indeed, Argentina has effectively banned the production of independent statistics.
Real' versus nominal prices
Because of inflation, we talk about values in 'real' and 'nominal' terms. 'Real' values are those that are adjusted for inflation, while "nominal" (the raw figures) are not.
It is important to distinguish between the two, especially since some figures are quoted in mainly nominal terms, and others in real terms. Economic growth is almost always given in terms of real GDP. However, investment returns (especially in the short-to-medium term) returns are usually given in nominal terms (especially in adverts).
You need to pay attention to the real rate. For example, interest rates of 0.5% are clearly bad news for savers. And given that the annual inflation rate is above 2% in both RPI and CPI terms, they look even worse.
Why? Because it means that in real terms, interest rates are negative. You are effectively paying to put money into gilts or a savings account. Say you put your money into a savings account paying 0.5%. It means that after accounting for inflation, the value of your money is actually falling each year.
This is why the economist Milton Freidman argued that unexpected inflation was effectively a tax on saving.
Of course, the flipside of this is that inflation can be good news for debtors. It reduces the real interest rate that they have to pay, and may mean that the value of their debt falls in real terms (although if their earnings don't keep up with inflation, this won't be the case).
How inflation affects the economy
So what causes inflation, and when does it become a problem?
One of the classic causes of inflation is demand-pull' inflation. This happens when a government, or central bank, stimulates the economy by increasing the money supply.
The money supply is usually boosted indirectly by cutting interest rates and lending money to banks in the hope that they'll increase the amount of credit. However, central banks are also able to create money, which can then be used to buy assets a much more direct method.
Either way, there's more money chasing the same amount of goods, which should result in higher demand and higher prices. Firms will respond by boosting output there's more demand for their stuff, so they make more. In turn this increases growth and employment.
However, companies catch up by raising their prices, and workers demand higher wages. So the economy returns to the previous level of output, but with higher inflation.
And if both companies and staff start to worry that inflation will get out of control, they can become locked in a vicious circle - a wage-price spiral. This is where workers demand higher wages in order to keep up with rising prices, which in turn forces companies to charge higher prices to keep up with rising wages.
As this gets worse, any savers who have not already been wiped out tend to take their money elsewhere, or hoard it in real' assets such as gold, or simply get rid of it as quickly as possible by swapping it for goods. This may make it hard for businesses to raise funds.
At extremes, hyperinflation can lead to a situation where money becomes worthless and people switch to bartering (or a shadow currency). The classic example of this is Germany in the early 1920s.
Unlike France and Britain, Germany paid for the costs of World War I by printing more money. This pushed prices up and drastically reduced the value of the mark (the German currency).
However, as one of the conditions for the peace treaty following the war, it had to pay a large amount of extra money in reparations. With the economy devastated by the war, it again turned to the printing presses.
Because the reparations were in a foreign currency and also in gold, the task was much harder, because the central bank had to print ever-increasing numbers of marks to buy back the same amount of debt. At its peak, prices in shops were being increased several times a day.
Cost-push inflation (stagflation')
Most experts focus on demand-pull inflation because it is easier to predict. Indeed, the economist Milton Freidman famously stated that "Inflation is always and everywhere a monetary phenomenon".
However, inflation can also be caused by changes in the cost base, as well as by demand. This type of inflation is nearly always bad since it raises prices without boosting demand.
Consumers have to pay higher prices, but their wages don't go up to compensate because companies are being squeezed too, and are often looking to lay people off. This is sometimes known as a 'supply-side shock'. A big enough shock can lead to 'stagflation',where both inflation and unemployment are high.
The classic example of this is the Western economies in the 1970s. The decision by Arab countries to first raise oil prices, and then to boycott the West in the aftermath of the Arab-Israeli war, caused the oil price to go up four-fold in less than a month. Inflation peaked in the UK at 25% in 1975. Overall, experts think that the spike wiped up to 8% from US GDP.
The Iranian revolution in 1979 caused a second major rise in the price of oil. Again, this hit Western economies hard. US inflation reached an annual rate of 15% in early 1981. Unemployment shot up to 7.6% in the same period. It took a tough central bank policy (under Paul Volcker) of raising interest rates well into double-digit territory to bring inflation down. However, it did so at a cost of higher unemployment, which peaked at 9.9%.
Of course, changes to the supply side are another way to help the economy on this front. For instance, low oil and commodity prices in the mid-1990s, combined with globalised labour keeping wages down, enabled economies to enjoy a combination of low inflation and strong growth. This led many to claim that central banks had cracked the problem of managing growth and inflation. However, the reality was that they had just been lucky.
Deflation: so far we've talked about rising prices. However, if inflation is too low or even negative you get deflation. This is where the process of cost-push inflation goes into reverse.
In this case, a fall in the money supply, or a cut in government spending, hits demand. With fewer goods being bought, company profits are hit. Because wages are sticky on the downside (it's hard to force people to take pay cuts), firms tend to cut output instead in other words, they fire people and make less stuff.
This means that employment and economic growth fall. Of course, prices and wages should eventually stabilise at lower levels. However, this process, sometimes called an 'internal devaluation', can be a long and painful process. Just as unexpected inflation taxes creditors (by making their savings worth less), deflation hits debtors (by driving up the real' cost of servicing their debt).
The classic example of a period of deflation was the Great Depression. In the US between 1929-33 the money supply fell by 25%, and prices fell by a third. Firms and farms that took on high levels of debt during the 1920s found that they were no longer able to pay back their creditors.
This led to a wave of repositions and bankruptcies, throwing millions out of work. Unemployment reached a peak of 25% in 1933. Government policies made things worse by using cartels, instead of a proper monetary stimulus, to prop up prices and wages. This added a supply-side shock to the cut in demand.
The US economy did not properly recover until the stimulus provided by World War II definitely not the ideal way to kick-start your economy.
Another case was the Japanese economy in the 1990s. A credit boom during the 1980s caused a property and stock market bubble. In order to burst it, the government increased interest rates.
The subsequent sharp fall in the money supply led to deflation and higher unemployment. It also left a huge amount of bad debt. Although money supply would later stabilise, it failed to grow strongly enough to boost demand.
As a result prices either stayed the same or declined, so growth continued to be very slow. This prolonged period of recession/stagnation has been called the 'lost decade'.
You can learn more about how inflation and deflation affect different assets in different ways by signing up for our MoneyWeek Basics email, which explains key investing concepts in short, clear, easy-to-grasp twice-weekly emails. It's completely free just sign up here.