wealth distribution

What causes inflation, and should we really worry about it so much?

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After decades of slumber, inflation is on the move.

Annual inflation has hit 4.9 per cent and the country’s biggest bank, ANZ, is tipping it will rise to a 30-year high of 6 per cent next year.

Central banks are holding on to the hope that it’s just a “blip”.

But some economists argue inflationary conditions now bear comparison with the 1970s when inflation reached 18 per cent.

What is inflation?

Inflation is most commonly-measured by the consumer price index (CPI).

That tracks the price of a huge basket of goods and services that are chosen and weighted every three years to be reflective of what people are spending their money on.

The CPI doesn’t take into account the changing price of existing houses and land, as Stats NZ considers those purchases to be investments, rather than consumption.

Stats NZ makes about 100,000 prices checks every three months to compile its quarterly consumer price index, visiting shops and websites to observe how prices have changed and surveying businesses on their prices.

Inflation is soon expected to be at a 30-year high.

Getty Images

Inflation is soon expected to be at a 30-year high.

What causes inflation?

Economists may not be certain of much, but they do know what causes inflation, as it is explained by the rock-solid law of supply and demand.

Prices will rise if there is more money chasing fewer goods and services.

And, at the moment, the fuse is burning from both ends.

Quantitative easing and other loose monetary policies have resulted in a huge increase in the money supply in most developed economies since the Global Financial Crisis in 2008.

In New Zealand, quantitative easing saw the Reserve Bank pump $54 billion into financial markets to ensure banks kept lending and to keep a lid on interest rates during the early stages of the Covid crisis.

At the same time, productivity growth – our ability to produce more goods and services – has taken a hit as a result of the Covid pandemic and other supply chain woes.

Our ability to “make more stuff” may be permanently challenged by rising carbon prices and other policy responses required to combat climate change.

More money to buy goods and services, and more difficulty providing them, sets the scene for rising inflation.

Econ Talks – inflation spikes to 4.9 per cent in September quarter.

So why isn’t inflation already worse than it is?

Up until recently, increases in the money supply since the GFC haven’t been reflected in rapidly rising consumer prices, and that is because money doesn’t cause inflation until it is actually spent.

As the river of money running through the economy has widened, it has become slower moving, and so it has only been spinning the wheels of demand with roughly the same old force.

According to the US Federal Reserve the “velocity of money” – the rate at which money is spent – has halved in the US since the late 1990s, plunging about 20 per cent since the start of the Covid crisis alone.

Quite literally, the dollar notes in circulation are changing hands less frequently, and the same is true for money held in people’s bank accounts.

It is hard to be conclusive about exactly why that has happened, and there seem to be both long-term and short-term factors at play.

Demographics and changing patterns of wealth distribution may be having an influence.

But it is also the case that the velocity of money has tended to fall in the past during recessions and periods of heightened economic risk.

So there are fears the trend could at least partially reverse as and when the world economy emerges from the shadow of Covid.

If that proves correct, the increase in money supply that has already happened could then come home to roost in much higher inflation.

As The Economist put it “some economists worry that the situation could quickly spiral out of control, if households all try to spend their money at once”.

Money is not changing hands as often.

Chris Skelton/Stuff

Money is not changing hands as often.

Why does high inflation matter?

Good question.

There is an argument that after having experienced so little inflation for so long, people may be a bit too afraid of it.

Overall, inflation – when looked at in isolation – should leave people no better or worse off on aggregate.

If people are paying more for goods and services because of inflation, that also means some people will be receiving more money for the goods and services they produce.

Those two things – the price we pay for stuff, and the price we get paid for making stuff – have to add up.

Every dollar we spend, including on tax, ends up in someone’s pocket, mostly as wages, but also in the form of interest payments, rent and profits.

It is what mathematicians call a zero-sum game.

A caveat is that if inflation is being caused by a rise in the price of imported goods, say higher petrol prices, then that means more of that money will end up in the pockets of people overseas, rather than at home.

‘Imported’ inflation from the likes of oil price rises will leave nations poorer, but ‘money in’ must equal ‘money out’.

AP

‘Imported’ inflation from the likes of oil price rises will leave nations poorer, but ‘money in’ must equal ‘money out’.

But it’s not that simple, right?

Not quite.

There are some small direct costs of inflation – the actual cost of putting on new price labels and changing advertising, for example – and some less trivial drawbacks in fluctuating rates of inflation.

Unexpected changes in the rate of inflation can make it harder for businesses to plan investments and for workers to negotiate pay, which could reduce economic activity somewhat, meaning fewer goods and services to buy.

If inflation spirals to the point of seriously undermining or even collapsing confidence in money as a short-term store of value or an efficient means of exchange, then that’s a totally different matter.

It is not on the cards, but hyperinflation of the ilk that Weimar Germany experienced in the 1920s and Zimbabwe suffered between 2007 and 2009 will always be in the back of the mind of central bankers.

In Germany in 1923, inflation got to the point where wages often had to be renegotiated and paid every day and some banknotes were literally not worth the paper they were printed on.

As German economist Karl Otto Pohl put it: “Inflation is like toothpaste. Once it’s out, you can hardly get it back in again. The best thing is not to squeeze too hard on the tube”.

If hyperinflation gets to the point where confidence in a currency collapses, money will struggle to do the job it’s designed to do, which is to serve as a means of payment and a short-term store of wealth.

Stuff

If hyperinflation gets to the point where confidence in a currency collapses, money will struggle to do the job it’s designed to do, which is to serve as a means of payment and a short-term store of wealth.

And there are winners and losers?

Potentially.

In theory, if annual inflation doubles from 5 per cent to 10 per cent, you might expect average wages, interest rates, rents and profits to also jump by 5 per cent.

And you might expect the value of the New Zealand dollar to decline by 5 per cent against other currencies to compensate.

But raising prices and negotiating higher pay to reflect inflation can be easier said than done for some businesses and workers, particularly in sectors of the economy that are highly competitive.

Unexpected inflation will be positive for borrowers – including indebted governments – and correspondingly bad for savers, assuming they are paying or receiving a fixed-rate of interest that can’t immediately adjust to match.

Even so, that doesn’t sound so scary

Maybe not, but inflation can’t usually be viewed in isolation.

Rising inflation may be best regarded as a symptom of sickness in an economy rather than the disease itself, or perhaps occasionally as a part of the treatment plan.

Getting back to the causes of inflation, if inflation is being caused by a drop in productivity and “too few goods”, then that is clearly a serious underlying condition.

The implication is that wages will not in fact be able to rise to fully compensate for inflation, and living standards will be eroded.

If, on the other hand, inflation is being caused by “too much money”, then there is also likely to be a problem condition underlying that.

It may be that the…

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