In the last week many TV figureheads and politicians in the US have been speaking of rising inflation. Many economic commentators in Europe and Asia have also begun addressing this issue shortly after. Some see in recent data from Germany a hint of spill-over effectsto the EU and other developed countries. Others consider prices in the US a cautionary taleon the combined inflationary effects of re-opening, recovery and fiscal stimuli.
Yet, all these conversations may sound rather abstract for those who are not familiar with the meaning of inflation. Even more so for younger people who were not born yet at the time of the stagflation, in the 1970s. As a matter of fact, the term ‘inflation’ was trending on Google search as people tried to learn more. Thus, to understand why US inflation data are globally relevant one needs to lay down a few basic definitions.
What is inflation? An example
The term inflation describes one of the key phenomena of macroeconomics, which numerous scholars have studied attentively. Put it simply, inflation quantifies the increase (positive change) in the prices of a good or service over time.
In fact, it is intuitive that there are two basic factors on which prices almost always depend, to some extent. First, there is the use value of goods and services for the people who buy them. This is an ‘intrinsic’ valuedependent on “the physical properties of the commodity” or the welfare gain of the service. Second, the exchange value putting the good’s/service’s value in relation to that of all other goods and services. At the most basic level, the exchange value implies the possibility of a barter: an apple is worth two bananas.
However, and this is where inflation enters the scene, one can express a good’s exchange value also in monetary terms. Serving as a conventionally accepted unit of measurement, monetary prices express exchange value in an easily understandable and agreeable way.
Value use and exchange value
Clearly, these two forms of value are usually quite closely related, which makes it harder to grasp inflation.
Abstractly, the price (exchange value) of some foods is higher than of that of the same quantity of others. Concretely, let’s assume that a supermarket sells chicken breast meat at $7.00 per kilo and apples for $2.00 per kilo. The chicken-to-apple exchange value is $7/$2=3.5, which suggests that chicken’s use value is 3.5 times larger than for apples. Nutritionally, chicken is richer than apples as it contains 2.5 times more calories. Moreover, it is packed with proteins, which help keeping hunger at bay for longer. Thus, one of the reasons for the inequalities in prices lies in the differences in use value. In this example, in the fact that a chicken is more nutritious and filling than apples are.
Money’s value
Generally, the barter exchange value (for exchanges between goods) is what tends to remain more or less constant. The value use of meat may decrease in a world where more and more people are turning vegan or vegetarian. Yet, these tend to be marginal fluctuations. However, there is no intrinsic law that imposes a good to cost exactly that amount of dollars per kilo. On the contrary, the monetary exchange value (money-price or monetary price) of good for money is more unstable. The barter may remain stable even if the money-prices of several goods increase in the same proportion — say, 20%.
For instance, if the price of chicken and apples increased by 20% next year, they would cost $8.40 and $2.40. With a calculator one can easily find out that their barter exchange value would not change $8.40/$2.40=3.5. Yet, in 2021 one could buy five kilos of apples with $10. While the same note will only buy a little more than four kilos in 2022.
What has changed is the value of money itself.
Hence all the problems
The reasons why the value of money may change are various. Schematically, one can distinguish three types of inflation according to their source: (scarce) supply, (excess) demand or (expensive) inputs.
For start, if the goods and services that money buys become scarcer their use valueis going to increase. Even if there is not more money in circulation, prices of rare goods will rise — so-called supply inflation.
Similarly, like any other good or service, it is less worthy when it abundant. That is to say, as the central bank prints more money and the government signs more checks money devaluates. In fact, the more money people have, the more they will be able to spend. Usually, supply cannot adapt fast enough – you cannot raise chicken or grow apples overnight – there will be excess demand. In this situation prices also rise — termed demand inflation.
Finally, prices may increase because the price of one of more raw materials’ price is soaring (input inflation). An example of this mechanism is at play whenever the price of oil rises. In the previous example, transporting chickens and apples may become more expensive due to heightened gasoline and diesel prices.
Why to worry? Inflation and policy-making
Recently, inflation has not posed any problem in developed economies. If anything, the issue was actually the opposite: deflation or a reduction in prices due to enduring economic crises. Actually, inflation usually resembles a phenomenon as innocuous for an economy as the growth of men’s beard. In effect, a moderate inflation can be as beneficial as a beard is for some men’s appearance. If there was no inflation, people could just keep all their saving under the mattress, suffocating the baking system. As a consequence, small and medium enterprises without access to capital markets would be unable to borrow money to invest.
Thus, policymakers endeavour to strike a sustainable balance of positive but stably low inflation. Usually, the Central Bank’s mandate expresses this aim by pursuing an inflation somewhere close to 2%, but slightly lower. In other words, the same five kilos of apples that $10 would buy in 2021 should cost $10.20 in 2022. Hence the issue of how to measure inflation.
The Consumer Price Index
The standard approach employs the Consumer Price Index (CPI) and involves a representative basket of goods and services.Every year statistical agencies make inquiries about consumers’ habits to determine how much the ‘typical’ buyer spends on what. The higher the expenditure for a given good or service (e.g., apples as opposed to papayas), the ‘heavier’ its weight. And heavier weights mean that the same proportional change in monetary price generates more inflation all other factors being equal.
Here is a short example using US data. Let’s suppose that all the expenses related to housing increase by 10%, while medical care and apparel fall by 5%. All other expenses increase by 2% as per the Central Bank’s target. At the end of the year, total inflation will be 3.84% — without those decreases it would be over 5%.
The use of CPI inflation usually gives rather volatile results due to the relevant weight assigned to utilities and fuels. However, in normal times it is a rather trustworthy measure of how most people perceive the changes in prices. Yet, CPI figures are only as good as their reference basket. If the assortment hitherto analysed is representative of consumers’ real habits, CPI will provide powerful descriptions. But updating the basket takes time, and usually overhauls take place only every few years. Thus, when habits are changing fast due to an unpredictable exogenous shock, as with the lockdowns, the basket lags behind. True, the FED and other central banks to do not use CPI, but alternative measures that circumvent this problem. However, data collection remains an issue when policymakers have to take split-second decisions.
Paying attention to the data
According to established views, excessive inflation can turn into a pathology and bring a State on the brink of ruin. This is what happened in interwar Germany, when the State printed more money to face enormous expenses. Extremely high inflation (hyperinflation) rapidly devaluates saving and salaries, reducing people’s purchasing power — especially for the poorest earners and retirees. Yet, despite talks of unusually high inflation, no major economy is anywhere near alarming levels of inflation.
If anything, the current rise in prices is an optical illusion. Comparing today’s prices with those recorded last year, at the peak of the pandemic is misleading. As everyone knows, even an average-height person may look like a giant in comparison to a midget. Equally, current prices compared to those of last year’s look impressively higher. Yet, if the comparison is drawn with two years ago, the situation appears less alarming. The 24-month change in prices for selected goods is the easiest way to materialise the distortion in data for 2021. Figure 3 shows clearly that prices in the US are more volatile today than they were two years ago. But it also signals the presence of both inflationary and deflationary drives.
Conclusion: A temporary surge in inflation
In conclusion, the current soar in inflation in the US does not show the basic traits of a looming crisis. At least for now. A rise in prices is physiological after a recession. This time it may appear more intense because demand had not disappeared due to a generalised economic collapse. Rather, governments suppressed consumers’ desire to spend by imposing lockdowns while fiscal stimuli have been supporting income and demand.
Moreover, if China’s experience in forerunning post-pandemic recovery is of any help, inflation in the US will be temporary. In fact, all three sources of inflation are here at work, but they primordial causes are not systemic. First, there is a supply inflation because many factories shut down and ship floated in the harbours for several months. Thus, as demand returns there are several supply bottlenecks — which events such as the blockage of the Suez Canal worsen. Second, there is demand inflation since the end of lockdowns allows people to spend money in ways they could not. The rise in aggregated demand would have driven prices up in the short term even without supply slowdowns. Finally, there is input inflation because oil prices have picked up in comparison to their historical lows in 2020. This affects goods and services through higher transportation costs and prices for plastics, electricity, et cetera.
Thus, the initial rebound may be inebriating, but the hangover will not last. Even China has seen its recovery slowdown after the immediate post-lockdown boom — and inflation drop. And, assuming that this inflationary pressure will be temporary there can be some positive sides to it. A 3–4% rise in the CPI index for two–three months will not make central banks discontinue their stimuli. Moreover, some inflation may help some borrowers – especially small enterprises – and pave the way for a healthier recovery.
