Understanding Inflation and its Global Impact (Part 2)

June 21, 2024 6:04 PM +07:00

CONSEQUENCES OF INFLATION

Value of Money

The most obvious penalty of inflation from a consumer point of view is the higher cost of goods and services. This translates to a decrease in the value of money as individuals can now purchase fewer goods and services with the same amount of money prior to an inflationary rise.

Wealth Gaps

The inequitable distribution of inflationary pressure amongst individuals can lead to changes in wealth. For example, individuals with loans during periods of high inflation will benefit as the real value of their debt repayments will fall over time while others may not.

Inflation Volatility

Fluctuating or erratic inflation data complicates business operations as businesses do not know where to set prices, and this can have a negative effect on the economy as both businesses and consumers adjust to the higher rates of inflation. Long-term business deals will also incur higher costs as volatile inflation causes a higher risk premia on hedging costs, which can reduce foreign investor confidence.

Central banks use of Inflation Targeting

Inflation targeting is quite simple in theory as involves a central bank setting a specific inflation goal in percentage terms. This strategy is achieved by manipulating monetary policy. The goal of inflation targeting allows central banks along with the public to have more clarity in terms of future expectations. The reason behind inflation targeting is control with regards to price stability, and price stability can be attained by governing inflation.

Generally an inflation target of 1% - 2% is familiar as it allows governments and central banks some flexibility at this low base. As a rule of thumb, any deviation greater than 1% either side of the targeted figure is cause for concern and has generally lead to policy intervention.

How do Governments Control Inflation?

There are many ways governments go about controlling inflation which can have knock-on effects (positive and negative) to the economy depending on current economic conditions. The most common way is via contractionary monetary policy which is used by central banks to curb inflation by restricting liquidity. This is achieved via 3 main avenues:

1. Decrease Money Supply

Decreasing money supply simply gives consumers less money to spend overall and should help limit inflation. One way this can be realized is by increasing interest on sovereign bond payments which can attract more investors to buy bonds.

2. Reserve Constraints

Restricting the amount of money banks are allowed to keep can influence the amount of money being lent to consumers. That is, if banks are required to keep higher amounts of money as a legal threshold, then naturally banks will have less money to lend. This should decrease consumer spending and thus, inflation.

3. Raising Interest Rates

Higher interest rates which result in fewer individuals willing to borrow and therefore leads to a decrease in spending. There’s also a greater opportunity cost of investing capital into a business given the higher rates of return that could be had through capital markets.

GLOBAL INFLATION AND KEY RELATIONSHIPS

Advanced vs Developing Economies

Source: World Bank

The chart above shows a consistent and logical pattern whereby the historical inflation rate in developed countries is generally less than emerging and developing economies (EMDE).There are two primary reasons behind this:

EMDE generally have higher growth rates which can lead to excess demand.
Volatile currencies are present in many EMDE which makes central banks’ management of monetary policy more difficult than those in advanced economies.

THE PHILLIPS CURVE

The historical relationship between unemployment and inflation has been largely inverse which means that high levels of unemployment correlates with lower inflation and vice versa. The reason why the inverse relationship exists is best explained with basic economics. For example, an increase in aggregate demand which is a consequence of demand-pull inflation, results in higher prices of goods and services and lower unemployment. This lower unemployment means that there is more income available in the economy to spend on goods and services. Both elements have recurrent effects on one another and is best represented by the basic Phillips Curve (see chart below).

The Phillips Curve

INFLATION: CONCLUSION

This article has demonstrated the wide reaching implication of inflation from more concentrated effects to wide-ranging systemic global impacts. Inflation is an important economic tool from a macroeconomic perspective but also can be powerful if understood and implemented within a trading strategy as inflation data can cause changes in price in many financial markets.