Inflation: A Primer

• The economic effects of COVID-19 have triggered many questions regarding price dynamics in the aftermath of the pandemic
• Inflation is affected by many domestic and foreign factors, which often differ between countries.
• CPI inflation is the most common measure of inflation but is it the most accurate or useful?

The COVID-19 pandemic has caused substantial economic damage across developed and developing economies. While the current fall in demand is causing deflationary pressures, amplified by the fall in energy prices, these are arguably temporary factors, while the limitations on credit flows to global productive capacity especially in Asia, disrupted supply chains, and the historical monetary and fiscal stimulus implemented by central banks and governments across the world may suggest higher inflation in the medium to long term. Understanding the factors affecting inflation and in what ways price levels, in return, affect other aspects of the economy is therefore crucial, especially in today’s uncertain economic environment.

Inflation is the measure of increases in the price level. Inflation acts as an (inverse) proxy for changes in the purchasing power of a currency within a country, much like the exchange rate is a proxy of purchasing power of a currency relative to other currencies. A negative rate of inflation (deflation) will increase a consumer’s purchasing power with time and therefore lead them to delay spending, slowing economic activity. Meanwhile, an excessively high level of inflation will lead consumers to ‘protect’ their wealth and spend more in the present to avoid higher prices in the future, leading to inconsistent economic growth. Most monetary authorities therefore target a low but positive inflation rate.

Measuring inflation

The most common measure of inflation is the Consumer Price Index (CPI), which measures the difference in the ‘cost of living’ between two points in time, which is representative of price increases for consumers but may not be representative of prices across the entire economy. Headline CPI aims to calculate the price increases of the basket of goods meant to represent the consumption basket of an average consumer. Another generally followed measure of inflation is core CPI, which excludes items that have volatile prices such as food and energy, in order to exclude seasonal or temporary spikes in inflation. While food and energy are key expenditure components for consumers and therefore should not be excluded from the inflation measure, including them in the calculation can also cover up some underlying economic fundamentals. Another measure used by several countries, such as Australia and the US, is the trimmed-mean CPI, which eliminates items that have the largest changes in inflation. This aims to eliminate one-off large changes in prices. However this could raise allegations of inconsistency and somewhat ‘convenient’ adjustment of official inflation data. Moreover, if a certain good essential to consumer spending is consistently trimmed, this could be a misrepresentation of actual price changes for consumers and within the economy.

The ways in which CPI is calculated between countries often differs. This can be due to different representative baskets, different weights for each good or service, different calculation methodologies, arbitrary adjustments made to the baskets, and even differences in the population that is being surveyed. This raises the question whether inflation can be accurately compared between countries in order to estimate changes in the relative purchasing power of their currencies. In the Euro Area, inflation is calculated as a weighted average of national Harmonised Indices of Consumer Prices (HICPs) for the Euro Area countries. Taking the average of all Euro Area countries’ inflation ensures price stability in the Euro Area as a whole but not in individual countries.

Controlling inflation

Central banks set short-term interest rates and aim to control the longer-term cost of money through policies such as inflation targeting, quantitative easing and yield curve control. The bank’s decisions feed through to several aspects of consumer spending as well as inflation expectations. While lower interest rates are inflationary for consumers and the demand side of the economy, it is arguably deflationary for the production, supply side of the economy. Moreover, many elements in the CPI basket have very little chance of being influenced by the central bank’s monetary policy such as commodity prices and the degree to which an economy is privatised, as inflation has a tendency to be lower in the public sector since prices are controlled by the government. There is also a lag between a central bank’s monetary policy decision and its effect on inflation, highlighting the importance of inflation expectations and economic outlook. Expected inflation is however difficult to estimate, and consumer inflation expectations, which ultimately affect consumer behaviour and therefore CPI, are generally higher than the official CPI numbers. Central banks generally choose to look at professional forecasts or market expectations, which are often in line with the CPI prints.

Politicians will also often push for reductions in the prices of consumer goods and services in order to gain support of voters, creating political pressure not only for lower inflation but decreasing prices. There are also conflicting pressures between lenders and borrowers in an economy whereby the latter will opt for higher levels of inflation as it deteriorates the value of their borrowings; the same is applicable for government debt when inflation is above the nominal interest rate.

Inflation is also dependent on economic stability, which is affected by factors such as political instability, supply shocks due to strikes, as well as exposure to external shocks such as exchange rates, commodity prices, and the weather. Emerging markets are often more exposed to such factors due to structural differences in their economies compared to developed countries, which contributes to consistently higher levels of inflation in the former.

Inflation and exchange rates

Inflation can affect a currency’s exchange rate through interest rates in the short term and money supply in the longer term. Increases in money supply may however not feed through to consumers in order to affect CPI, while potentially affecting prices in other parts of the economy. The effect of exchange rate changes on domestic inflation is known as exchange rate pass-through. Exchange rate fluctuations can cause higher inflation as a result of higher uncertainty, higher direct import prices, and higher prices of imported goods for production, feeding through indirectly to domestic consumer prices. Additionally, if a country’s trade is largely denominated in a foreign currency, its inflation rate becomes partially dependant on the exchange rate and consequently inflation and monetary policy in the trading partner’s country.

Another method of estimating price changes in a country is through Purchasing Power Parity (PPP). Contrary to CPI, PPP is calculated using a range of final goods and services that are included in GDP, therefore includes not only household consumption expenditures but also government expenditures and gross fixed capital formation expenditures. Purchasing Power Parity (PPP) states that the cost of the same good is the same between two countries, when adjusted by the exchange rate. Differing inflation rates between countries are therefore a fundamental cause in evaluating the purchasing power of their respective currencies.

A long version of this primer with more detail and insight into inflation dynamics can be accessed by contacting a member of the Economic Research team at economicresearch@recordcm.com