Americans and citizens worldwide have witnessed inflation rates soar over the last two years. The past year saw inflation climb to a 40-year high. Increasing costs seem to be everywhere, from food at the grocery store to gas prices to your favorite retail store.
But what is the cause of high inflation? And is there any chance of rates declining? Keep reading to find out more.
What is inflation?
Before you get into the weeds about what causes inflation, it’s helpful to understand the concept at its core. Inflation is the measured rise in the personal consumption expenditures price index (PCE), which is the cost of goods and services during a specific period.
Most often, inflation rates are measured by the year to track the scale of goods and services. However, when an economy is experiencing a more tumultuous time, it is common for inflation to be measured more often, like every month.
Higher inflation in the short term can lead to skyrocketing commodity prices and dwindling purchasing power in the U.S. economy.
How is inflation measured?
To measure inflation, economists use the consumer price index (CPI), a formula that assesses the cost of living and how it fluctuates. The CPI requires two variables:
- Value of market basket in a particular year.
- Value of market basket in a base year.
You can use the CPI by plugging these variables into the following equation:
- Consumer Price Index = Value of Market Basket in Particular Year / Value of Market Basket in Base Year x 100
What are the types of inflation?
Different types of inflation can occur depending on international or domestic factors and how the economy reacts to them. The main types of inflation include:
What causes inflation?
In general, a few leading causes of inflation have happened across the globe throughout history.
- Money supply: When people experience an increase in income or spending opportunities, they are more likely to spend before they save. This often causes more demand than there is supply. This cause is linked to demand-pull inflation.
- Supply shocks: Inflation is sure to follow if there is a significant disruption to a particular supply chain due to a world event, strike, or other reasons. This cause is linked to cost-push inflation.
- Expectations: When what happens in the economy does not match the expectations, it can cause inflation. For example, companies generally create products based on the expected consumer demand. However, an unexpected increase in demand with no supply to match it can throw things out of whack.
Why is inflation so high right now?
Just as the economy began to level out and supply chain issues started to heal, a major foreign conflict occurred. This caused the perfect storm of demand-pull and cost-push inflation, causing some of the highest inflation rates in history.
Keeping that base knowledge of inflation in mind, here are two key reasons inflation is so high.
1. The Covid-19 pandemic
The pandemic caused a classic case of demand-pull inflation. A few factors can cause demand-pull inflation; however, in this case, it is mainly caused by household spending.
Throughout history, demand-pull inflation often happened after wartime. For example, when World War II ended, the country’s economy experienced a boom it was not quite expecting.
Because people were celebrating the war’s end and living more carefreely, they began to make more purchases than they had in previous years. This caused a rapid shift in the economy as demand soared above supply.
A similar phenomenon occurred when lockdowns were lifted, and people became more comfortable resuming everyday life as the pandemic began to wane.
People began buying again, but the purchases happened more rapidly than the slowed supply chain could handle. And when the demand is that much greater than the supply, shortages and price increases occur.
2. Russia’s invasion of Ukraine
Politics aside, foreign and domestic conflict affects the functions of the world’s economy. Russia and Ukraine supply the world with essential commodities, and because of the supply chain disruption the war has caused, sanctions were imposed and higher prices became inevitable.
With these two countries at war, significant shifts and shortages are happening worldwide.
There are four key areas where the world is seeing the harshest effects:
- Food: Russia and Ukraine supply the world with one-fourth of its wheat, one-fifth of its cornand coarse grains and 80% of its sunflower oil. Because of the conflict, global food prices have increased by 17%.
- Transport: Russia is one of the world’s foremost suppliers of palladium, mine production, platinum, titanium and fertilizer. These commodities contribute to significant industries like automobiles, aircraft and farming.
- Energy: Russia is a massive contributor to the world’s oil and energy industry. In June, the price of Brent oil surged to $120 per barrel, and overall energy prices have increased by 30%. Energy used in the U.S. accounts for 7.6% of the CPI, leading to further inflation and a global energy crisis.
- Financial Markets: When stocks are unpredictable, like during a conflict, global stock prices generally see adverse effects due to tentative trades and divestments.
Will inflation decline any time soon?
Nobody knows for sure. According to historical trends, inflation is the expected result of a considerable economic disruption, like a pandemic or a war.
However, the economy has been somewhat unpredictable, even with history to learn from. Economists all over the globe continue to gather data and study trends to make the most accurate forecasts. Some of those predictions include the following:
- Federal Reserve (Fed): The central bank of the United States believes that inflation will peak in 2022 and begin to decline in 2023 but will not return to its 2% target until 2025.
- Morgan Stanley: Inflation will peak in 2022’s fourth quarter.
- Goldman Sachs: Core PCR inflation will fall from 5% in 2023 to 3% year-over-year.
- World Economic Forum: Inflation rates will decline from 8.8% in 2022 to 6.5% in 2023 to 4.1% in 2024.
What does inflation mean for you?
A variety of factors can cause inflation, including those the world is experiencing now: the aftermath of a pandemic followed by a foreign war. While many economists predict deflation on the horizon, there is never a surefire way to know.
To protect yourself against inflation, be sure to budget accordingly, create an emergency fund, invest wisely and keep a close eye on the interest rates of any debt you may have.
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