INFLATION BACK TO BASICS

What are the causes of inflation and who controls it?

BY DR SOHA MAAD

Introduction

This article sheds light on the accelerating trend of rising world inflation. The article alerts banks and government authorities in Arab countries to address the challenge by going back to the basic causes of inflation in order to solve the problem from its root bases. Following the highlight of this alerting rising inflation trend, the article goes back to the basics of inflation. The article overviews the various types of inflation and causes, measures of inflation, control of inflation, impact of inflation on various economic stakeholders, hedging against inflation, and the relationship between inflation and recession. The article concludes with recommendations for Arab banks and authorities to go back to the basics to tackle the inflation problem starting from its root causes.

RISING TREND OF WORLD INFLATION

According to Pew Research and New York Times, in 2022 inflation rates in the United States and around the world rose to their highest levels since the early 1980s. While there is no single reason for this rapid rise in global prices, there has been a series of events that have worked together to trigger it. The COVID-19 pandemic in early 2020 led to lockdowns and other restrictive measures that greatly disrupted global supply chains, from factory closures to bottlenecks at maritime ports. At the same time, governments issued stimulus packages and increased unemployment benefits to help mitigate the financial impact of these measures on individuals and small businesses. When COVID-19 vaccines became widespread and the economy rapidly bounced back, demand for goods and services, fuelled in part by stimulus money and low interest rates, quickly outpaced supply, which is still struggling to get back to pre-COVID levels.

Separately, Russia’s unprovoked invasion of Ukraine in early 2022 led to a series of economic sanctions and trade restrictions on Russia, limiting the world’s supply of oil and gas, since Russia is a large producer of fossil fuels. At the same time, food prices rose as Ukraine’s large grain harvests could not be exported. As fuel and food prices rose, it led to similar increases down the value chains.

FACTS AND FIGURES OF rising world inflation

Pew Research Center analysis of data from 44 advanced economies reveals that, in nearly all of the considered 44 economies, consumer prices have risen substantially since pre-pandemic times.

In 37 of the 44 nations considered in the analysis, the average annual inflation rate in the first quarter of year 2022 was at least twice of the previous two years. In 16 countries, inflation in the first-quarter of year 2022 was more than four times the level of two years ago. The analysis is based on data from the Organization for Economic Cooperation and Development OECD. The data covers 37 of the 38 OECD member nations, and seven other economically significant countries.

Among the countries studied, Turkey had by far the highest inflation rate in the first quarter of 2022 reaching 54.8%. Turkey has experienced high inflation for years, but the inflation rate rose sharply in late 2021 as the government pursued economic policies, such as cutting interest rates rather than raising them.

The country where inflation has grown fastest over the past two years is Israel. The annual inflation rate in Israel had been below 2.0% every quarter from the start of 2012 through mid-2021. In the first quarter of 2020, the inflation rate was 0.13%. But after a relatively mild recession, Israel’s consumer price index began rising quickly. It averaged 3.36% in the first quarter of year 2022, more than 25 times the inflation rate in the same period in 2020.

Besides Israel, other countries with very large increases in inflation between 2020 and 2022 include Italy, which saw a nearly twentyfold increase in the first quarter of 2022 compared with two years earlier (from 0.29% to 5.67%); Switzerland, which went from ‑0.13% in the first quarter of 2020 to 2.06% in the same period of this year; and Greece. Following the Greek economy’s near-meltdown in the mid-2010s, the country experienced several years of low inflation. Since then, however, prices have rocketed upward. The annual inflation rate in Greece reached 7.44% in the first quarter of year 2022, nearly 21 times what it was two years earlier in 2020 (0.36%).

Annual inflation in the United States in the first quarter of year 2022 averaged just below 8.0%, the 13th-highest rate among the 44 countries examined. The inflation rate in the first quarter of year 2022 in the United States was almost four times its level in the first quarter of year 2020.

Regardless of the absolute level of inflation in each country, most countries experienced relatively low levels of inflation before the advent of the COVID-19 pandemic in the first quarter of 2020. However, as many governments sharply curtailed most economic activity, rising inflation rates started in mid to late 2021, as the world struggled to get back to normal activity.

But there are exceptions to this general pattern. In Russia, for instance, inflation rates rose steadily throughout the pandemic period before surging in the wake of its invasion of Ukraine. In Indonesia, inflation fell early in the pandemic and has remained at low levels. Japan has continued its years-long struggle with inflation rates that are too low. In Saudi Arabia, the pattern was reversed. The inflation rate surged during the pandemic but then fell sharply in late 2021. Inflation in Saudi Arabia has risen a bit since 2021 but it is still just 1.6%.

An interim report from the OECD found that April 2022 inflation rates ran ahead of March 2022 figures in 32 of the group of 38 OECD member countries.

Back to basics: what is inflation?

Inflation is the decline of purchasing power of a given currency over time. A quantitative estimate of the rate at which the decline in purchasing power occurs can be reflected in the increase of an average price level of a basket of selected goods and services in an economy over some period of time. The rise in prices, which is often expressed as a percentage, means that a unit of currency effectively buys less than it did in prior periods.

Inflation can be contrasted with deflation, which occurs when the purchasing power of money increases and prices decreases.

TYPES OF INFLATION

There are various types of inflation including demand-pull, cost-push, and built-in inflation. These are overviewed below:

Demand-Pull inflation

Demand-pull inflation occurs when an increase in the supply of money and credit stimulates overall demand for goods and services in an economy to increase more rapidly than the economy’s production capacity.

With more money available to individuals, positive consumer sentiment leads to higher spending, and this increased demand pulls prices higher. It creates a demand-supply gap with higher demand and less flexible supply, which results in higher prices.

Cost-Push inflation

Cost-push inflation is a result of the increase in prices working through the production process inputs. When additions to the supply of money and credit are channelled into a commodity or other asset markets and especially when this is accompanied by a negative economic shock to the supply of key commodities, costs for all kinds of intermediate goods rise.

These developments lead to higher costs for the finished product or service and work their way into rising consumer prices. For instance, when the expansion of the money supply creates a speculative boom in oil prices the cost of energy for all sorts of uses can rise and contribute to rising consumer prices, which is reflected in various measures of inflation.

Built-in Inflation

Built-in inflation is related to adaptive expectations, the idea that people expect current inflation rates to continue in the future. As the price of goods and services rises, workers and many people expect that prices will continue to rise in the future at a similar rate. As a result workers demand more wages to maintain their standard of living. Their increased wages result in a higher cost of goods and services, and this wage-price spiral continues as one factor induces the other and vice-versa.

Causes of inflation

An increase in the supply of money is the root of inflation, though this can play out through different mechanisms in the economy. A country’s money supply can be increased by the monetary authorities by:

Printing and giving away more money to citizens.
Legally devaluing(reducing the value of) the legal tender currency.
Purchasing government bonds from banks on the secondary market.

In all of these cases, the money ends up losing its purchasing power. According to John Maynard Keynes, inflation is an imbalance between the aggregate demand and aggregate supply of goods and services. Therefore, if the aggregate demand exceeds the aggregate supply, then the prices keep rising. The various causes of inflation include:

Primary causes: In an economy, when the demand for a commodity exceeds its supply, then the excess demand pushes the price up.
Increase in public spending: In any modern economy, government spending is an important elementof the total spending. It is also an important determinant of aggregate demand.
Deficit financing of government spending: There are times when the spending of government increases beyond what taxation can finance. Therefore, in order to incur the extra expenditure, the government resorts to deficit financing. For example, it prints more money and spends it. This, in turn, adds to inflationary pressure.
Increased velocity of circulation: In an economy, the total use of money is the money supply by the government multiplied by the velocity of circulation of money. When an economy is going through a booming phase, people tend to spend money at a faster rate increasing the velocity of circulation of money.
Population growth: As the population grows, it increases the total demand in the market. Further, excessive demand creates inflation.
Hoarding: Hoarders are people or entities who stockpile commodities and do not release them to the market. Therefore, there is an artificially created demand excess in the economy. This also leads to inflation.
Genuine shortage: It is possible that at certain times, the factors of production are short in supply. This affects production. Therefore, supply is less than the demand, leading to an increase in prices and inflation.
Exports: In an economy, the total production must fulfil the domestic as well as foreign demand. If it fails to meet these demands, then exports create inflation in the domestic economy.
Trade Unions: Trade unionwork in favour of the employees. As the prices increase, these unions demand an increase in wages for workers. This invariably increases the cost of production and leads to a further increase in prices.
Tax Reduction: Sometimes, governmentsreduces taxes to gain popularity , this causes more money in the hands of people. However, if the rate of production does not increase with a corresponding rate, then the excess cash in hand leads to inflation.
The imposition of indirect taxes: Taxes are the primary source of revenue for a Government. Sometimes, Governments impose indirect taxes like excise duty, and Value Added Tax VAT on businesses. As these indirect taxes increase the total cost for the manufacturers and sellers, they increase the price of the product to have a minimal impact on their profits.
Price-rise in the international markets: Some products require to import commodities or factors of production from the international markets like the United States. If these marketsraise prices of these commodities or factors of production, then the overall production cost increases too. This leads to inflation in the domestic market.
Non-economic Reasons: There are several non-economic factors which can cause inflation in an economy. For example, if there is a flood, then crops are destroyed. This reduces the supply of agricultural products leading to an increase in the pricesof the commodities. Investment in gold, real estate, stocks, mutual funds, and other assets are some of the ways to deal with Inflation.

Inflation metrics

There are a few metrics that are used to measure the inflation rate. One of the most popular is the Consumer Price Index (CPI), which measures prices for a basket of goods and services in the economy, including food, cars, education, and recreation.

Another measure of inflation is the Producer Price Index (PPI), which reports the price changes that affect domestic producers. The PPI measures prices for fuel, farm products (meats and grains), chemical products, and metals. If the price increases that cause the PPI to spike get passed onto consumers, it will be reflected in the Consumer Price Index. Below is a description of the various price indexes:

The Consumer Price Index (CPI)

The CPI is a measure that examines the weighted average of prices of a basket of goods and services which are of primary consumer needs. They include transportation, food, and medical care. CPI is calculated by taking price changes for each item in the predetermined basket of goods and averaging them based on their relative weight in the whole basket. The prices in consideration are the retail prices of each item, as available for purchase by the individual citizens.

The Wholesale Price Index (WPI)

The WPI is another popular measure of inflation, which measures and tracks the changes in the price of goods in the stages before the retail level. While WPI items vary from one country to other, they mostly include items at the producer or wholesale level. For example, it includes cotton prices for raw cotton, cotton yarn, cotton goods, and cotton clothing.

The Producer Price Index

The producer price index is a family of indexes that measures the average change in selling prices received by domestic producers of intermediate goods and services over time. The PPI measures price changes from the perspective of the seller and differs from the CPI which measures price changes from the perspective of the buyer.

In all such variants, it is possible that the rise in the price of one component (say oil) cancels out the price decline in another (say wheat) to a certain extent. Overall, each index represents the average weighted price change for the given constituents which may apply at the overall economy, sector, or commodity level.

The Formula for Measuring Inflation

The price indexes can be used to calculate the value of inflation between two particular months or years. While a lot of ready-made inflation calculators are already available on various financial portals and websites, it is always better to be aware of the underlying methodology to ensure accuracy with a clear understanding of the calculations. Mathematically, percent inflation rate is measured as:

Percent Inflation Rate = (Final CPI Index Value/Initial CPI Value) x 100

Impact of inflation

While consumers experience little benefit from inflation, investors can enjoy a boost if they hold assets in markets affected by inflation.

Some companies reap the rewards of inflation if they can charge more for their products as a result of a surge in demand for their goods. If the economy is performing well and housing demand is high, home-building companies can charge higher prices for selling homes.

In other words, inflation can provide businesses with pricing power and increase their profit margins. If profit margins are rising, it means the prices that companies charge for their products are increasing at a faster rate than increases in production costs.

Also, business owners can deliberately withhold supplies from the market, allowing prices to rise to a favourable level. However, companies can also be hurt by inflation if it is the result of a surge in production costs.

Inflation often leads to speculation by businesses in risky projects and by individuals who invest in company stocks, as they expect better returns than inflation. An optimum level of inflation is often promoted to encourage spending to a certain extent instead of saving. If the purchasing power of money falls over time, then there may be a greater incentive to spend now instead of saving and spending later. It may increase spending, which may boost economic activities in a country. A balanced approach is thought to keep the inflation value in an optimum and desirable range.

Buyers of such assets may not be happy with inflation, as they will be required to shell out more money. People who hold assets denominated in their home currency, such as cash or bonds, may not like inflation, as it erodes the real value of their holdings. As such, investors looking to protect their portfolios from inflation should consider inflation-hedged asset classes, such as gold, commodities, and real estate investment trusts (REITs). Inflation-indexed bonds are another popular option for investors to profit from inflation.

High and variable rates of inflation can impose major costs on an economy. Businesses, workers, and consumers must all account for the effects of generally rising prices in their buying, selling, and planning decisions. This introduces an additional source of uncertainty into the economy, because they may guess wrong about the rate of future inflation. Time and resources expended on researching, estimating, and adjusting economic behaviour are expected to rise to the general level of prices, rather than real economic fundamentals, which inevitably represents a cost to the economy as a whole.

Even a low, stable, and easily predictable rate of inflation, which some consider otherwise optimal, may lead to serious problems in the economy, because of how, where, and when the new money enters the economy. Whenever new money and credit enters the economy it is always into the hands of specific individuals or business firms, and the process of price level adjustments to the new money supply proceeds as they then spend the new money and it circulates from hand to hand and account to account through the economy.

Controlling Inflation

A country financial regulator is the important entity responsible for controlling inflation. Inflation control is undertaken by implementing monetary policy measures. These refers to the actions of a central bank or other committees that determine the size and rate of growth of the money supply.

In the United States, the Federal Reserve (United States central bank) monetary policy goals include moderate long-term interest rates, price stability, and maximum employment, and each of these goals is intended to promote a stable financial environment. The Federal Reserve clearly communicates long-term inflation goals in order to keep a steady long-term rate of inflation, which is thought to be beneficial to the economy.

Price stability, or a relatively constant level of inflation, allows businesses to plan for the future since they know what to expect. Central banks role is to set monetary policies that can promote maximum employment and maintain price stability.

Hedging Against Inflation

Stocks are considered to be the best hedge against inflation, as the rise in stock prices is inclusive of the effects of inflation.

Special financial instruments exist that one can use to safeguard investments against inflation. They include Treasury Inflation-Protected Securities (TIPS), low-risk treasury security that is indexed to inflation where the principal amount invested is increased by the percentage of inflation.

Impact on the poor

High or unpredictable inflation that is not outmatched by wage gains can be especially hard for poor people.

Poor households spend a bigger chunk of their budgets on necessities such as food, housing and especially gas, which is often a contributor to bouts of high inflation. They spend less on discretionary expenditures. If rich households face high inflation and their wages do not keep up, they may have to cut back on vacations or dining out. A poor family may be forced to cut back on essentials, like food.

Relation between inflation and Recession

Experts do not anticipate a recession in 2022, but they recommend investors to position their portfolios defensively for the time being.

Growth stocks are particularly sensitive to rising interest rates because fund managers typically use discounted cash flow models to determine their price targets for growth stocks. Future cash flows are considered less valuable when the discounted rate is higher.

Inflation rates are forcing investors to shift their focus from accommodative monetary policies to underlying fundamental valuation metrics.

Financial experts foresee that price volatility will continue and policy measures should be adopted to control inflation.

Recommendations for arab banks

Based on the above overview of rising world inflation rates and the experts future forecast of continued rising inflation and prices fluctuation, we recommend Arab banks and authorities to address the inflation problem and resolve it from its basic root causes by developing:

a resilient monetary policy framework: central banks in Arab countries should adopt a resilient monetary policy framework that can help in reducing inflation gradually over time and reducing its harmful impact.
hedging financial instruments: Arab banks including Islamic banks should develop financial instruments to hedge against inflation.
Artificial Intelligence (AI) monitoring and decision support tools: central banks and financial institutions in Arab banks as well as financial technology companies Fintechs should develop artificial intelligence tools and techniques to monitor and control inflation and hedge against it.
Central Bank Digital currencies: Central banks in Arab countries should collaborate to develop a solid central bank digital currency that can help in maintaining stable inflation rates.

References

Investopedia, Wikipedia, Business Insider, New York Times, www.toppr.com, Forbes, PEW Research, OECD data, The Economist