Look, this is Germany in 1923. People were using banknotes to plaster walls and even burn for fuel. The German mark had become worthless, not even big enough for toilet paper. Prices doubled every two days on average. The annualized inflation rate reached...
This is Zimbabwe in 2008. They printed the famous banknote with countless zeros, 100 trillion Zimbabwean dollars. Prices doubled every 24.7 hours on average, with an annualized inflation rate reaching...7.3 times 10 to the power of… guess how much? 108! I can't even comprehend what that means.
And this is Hungary in 1946, where prices doubled every 15.6 hours on average. The annualized inflation rate...
We may treat these as jokes now, but for the economies at that time, it was an absolute catastrophe.
In 2022, soaring inflation in the US, EU, and UK brought the term back to the forefront of global economics. Today, let's try to understand inflation, its causes, and what governments and central banks are thinking. Are you ready?
What is Inflation?
Inflation literally means currency devaluation. The most common measure is the CPI, the Consumer Price Index, which tracks the price trends of goods and services we use daily.
Looking at the US CPI from 60 years ago, it was around 29, and now it's 296. While the absolute number might not seem significant, comparing the two shows that prices in the US are roughly ten times higher than they were six decades ago. In other words, one dollar back then is equivalent to about ten dollars today. That's lower than you might have imagined.
Looking at other countries, Australia's prices increased sixteenfold, the UK's by twenty-fivefold, India's by eighty-eightfold, and Turkey's by a staggering 9.7 million times over the same period.
Rising prices mean money is becoming less valuable. While this is easy to grasp, understanding inflation deeply requires examining it from an economic perspective.
Economists use numerous formulas and theories to explain inflation, like Keynesian, Monetarist, New Keynesian, and so on. They all seem reasonable but rarely work long-term. This is another fascinating aspect of inflation—its causes are surprisingly simple: the amount of currency circulating in an economy exceeds its economic output. Too much money chasing too few goods inevitably leads to rising prices.
However, managing it is challenging. The primary, and often sole, objective of central banks worldwide is to maintain price stability. They can print money, adjust interest rates, but their priority is controlling inflation.
Yet, achieving this remains a challenge. Even institutions like the Federal Reserve and the European Central Bank, comprised of top economists, often disagree. Clearly, it's not as simple as it seems.
From a macroeconomic standpoint, money is merely a medium of exchange. Therefore, its purchasing power, like whether my cup of milk tea costs $3 or $300, is less relevant. What truly matters is achieving greater happiness, well-being, and... well, that's a topic for another day.
Economically speaking, the goal is to achieve higher output, simply put, a higher GDP. This means everyone works hard, producing more and better goods and services for consumers to enjoy, resulting in a more efficient economy.
Inflation and Economic Growth
How can monetary policy help us achieve higher output? Considering money as a medium of exchange in an economy, maintaining its stability seems ideal. However, some argue that if the money in everyone's hands gradually depreciates, even money stashed under your mattress loses purchasing power due to inflation, transferring that power to newly created money. This creates a constant, subtle wealth redistribution. You're incentivized to invest, produce, and consume instead of hoarding money.
Essentially, inflation acts as a continuous wealth redistribution mechanism. For example, if a cup of milk tea costs $20 this year and $21 next year, you're encouraged to spend your money sooner, knowing it will be worth less in the future. This increased spending boosts aggregate demand, driving economic growth.
Therefore, a moderate level of inflation is generally considered beneficial for an economy. Of course, as consumers, we dislike the pressure to spend. However, economists prioritize economic development over consumer sentiment.
But what about deflation, where the same $100 buys more next year than this year? Wouldn't it be tempting to hoard money, effectively gaining wealth without working? However, this discourages work, investment, and spending, ultimately leading to a deflationary spiral.
Japan exemplifies this. After its economic bubble burst in the 1990s, it fell into deflation and three decades of stagnation. Despite central bank stimulus and government debt, demand remained stagnant. While cultural factors and an aging population played a role, deflation's detrimental impact is evident.
Cheaper prices are not the problem; it's the lack of work, productivity, and spending, leading to a low-desire society. We care about inflation not solely for price changes but for their impact on demand and GDP.
However, this wealth redistribution effect cannot be excessive. Losing a dollar's worth of purchasing power annually might be acceptable, but hyperinflation, like in Zimbabwe, where purchasing power evaporates rapidly, renders earning meaningless. This leads to a "spend-it-all" mentality, as saving becomes futile.
Hyperinflation and its Consequences
Hyperinflation, characterized by extremely rapid price increases, is devastating to economies. For instance, in post-WWI Germany, a loaf of bread cost 1000 billion marks, potentially doubling the next day. This crippled the financial and credit systems, causing production to plummet. Germany saw 6 million people unemployed within six months, leading to a new currency, military control, political turmoil, and indirectly contributing to Hitler's rise.
Historically, countries experiencing hyperinflation require extensive reforms and reboots to recover. Deflation resembles a frozen economy with limited growth, while hyperinflation is like an overheated economy self-combusting, each feeding the other, and both are detrimental.
Why Target Inflation?
Understanding the dangers of deflation and hyperinflation clarifies why most economists aim for moderate inflation. Central banks in the US, Europe, UK, Japan, Canada, and Australia set inflation targets between 2% and 3%. While not always explicitly stated, most central banks aim to keep inflation within 2% to 5%, even at the cost of short-term economic growth or even recession. Controlling inflation is paramount for developed economies.
Inflation and Asset Prices
Some might wonder about inflation's impact on asset prices like stocks and real estate. While it's difficult to definitively say due to numerous factors, intuitively, one might assume a positive correlation. As prices rise, people might invest in assets like real estate or stocks to hedge against inflation.
Interestingly, an IMF study on 71 economies found a negative correlation between stock prices and inflation in both developed and developing countries. This means stock prices generally fall during high inflation periods.
This is because policy responses to high inflation, both fiscal and monetary, tend to be contractionary, leading to stock market declines. Turkey is an exception, as they didn't implement contractionary policies during high inflation, resulting in their stock market tripling in a year.
Another exception is energy company stocks, which generally perform well during high inflation, as seen in 2022.
Causes of Inflation
While it might seem intuitive to blame central banks for printing too much money, the reality is more nuanced. Inflation can occur without central bank intervention and, conversely, excessive money printing might not always lead to inflation, as seen in Japan's decades-long struggle with deflation despite quantitative easing.
Three primary factors contribute to inflation:
1. Demand-Pull Inflation:
Imagine a normal economy suddenly developing an insatiable thirst for milk tea. This additional demand, under otherwise normal conditions, would lead milk tea shops to either increase production or raise prices, both benefiting the shop owners.
These owners, now wealthier, would spend more, boosting other sectors like clothing or food, creating a ripple effect. This cycle of increased demand, production, price increases, higher profits, and further spending drives economic growth but also causes inflation as a side effect.
This demand-driven growth is evident in various sectors. For example, the demand for stock trading led to online platforms, and later, the demand for a one-stop investment platform led to platforms like Moomoo, offering access to various markets and assets.
2. Cost-Push Inflation:
Now, imagine those milk tea shops needing to expand production to meet surging demand. However, they face limitations like limited labor availability. In this scenario, raising prices becomes a solution, leading to inflation.
This is similar to the situation faced by governments implementing quantitative easing amid already high inflation.
3. Government Printing Money:
Uncontrolled money printing by governments usually stems from wars or political instability. Unless desperate, governments understand the consequences of this unsustainable practice, as seen in post-WWI Germany and post-WWII Hungary, where war reparations forced them to print money, ultimately fueling hyperinflation.
While printing money initially stimulates demand and economic growth, excessive printing leads to rapid inflation. When inflation becomes too high, wealth redistribution accelerates, discouraging saving and focusing solely on immediate needs.
Even if the government halts printing at this point, the damage is done. Reduced productivity due to decreased work hours leads to decreased supply, further pushing prices up and exacerbating inflation, creating a vicious cycle.
Conclusion
Understanding these complexities helps us grasp the challenges faced by central banks in managing inflation and their focus on maintaining a delicate balance. Their decisions impact not just prices but the entire economic landscape, making their role crucial in ensuring sustainable economic growth.