A few weeks ago, a friend and I were getting a Boojum. I recall that, prior to the pandemic, student deals were €6.50, and they are now €8.50. I then overheard a fellow student aptly say “inflation baby”. Inflation is something which is all too familiar given the current rising cost of living, but what does it really mean?
Inflation is something that will be ever-present throughout our lives. I hope to help explain the current situation to students who may not know much about macroeconomics, with the aim of helping them understand inflation as they encounter it throughout their lives.
What is Inflation?
Inflation is the increase in price levels from one period to the next. It is measured using the Consumer Price Index (CPI). The Consumer Price Index measures the variation in price between time periods for an average selection of consumer goods. Prior to the pandemic, inflation in Ireland stood at around 0.9% in 2019, with predicted inflation of around 2% moving into the future. An inflation rate of around 2% is seen as the ‘goldilocks level’ of inflation, as it means the economy is growing, but not too fast or not too slow – just right. A high rate of inflation is undesirable and indicates an overheating economy. We are currently in this situation.
Currently, inflation stands at approximately 6.7%. Such a rate of inflation has not been seen in over 20 years. The Central Bank forecasts that inflation will peak at 7.7% in the second quarter of 2022, remaining above 7% in the third quarter before falling to around 5% towards the end of the year.
You might be thinking that higher prices mean producers are earning more and therefore employees should get higher wages, right? While in theory, this is correct, this is only looking at the revenue side of things. Inflation is a vicious circle. The cost of materials increases, pushing up the price of products, employees need higher wages to offset the rise in the cost of goods, which in turn pushes up producers’ costs and so on and so forth. This is known as a domino effect: one event feeds into another.
Another important effect of inflation is that it erodes the value of savings. Thanks to inflation, €10 won’t get you as much in the shops today as it would have this time last year. The erosion of the value of savings has serious consequences for consumers, businesses, and governments. Inflation also affects interest rates, as lenders demand compensation for the decrease in the purchasing power of the money they receive in the future.
Why is the current rate of inflation so high?
There are several reasons for the high rate of inflation that we are currently witnessing. During the pandemic, people were largely unable to spend money thanks to lockdowns and as a result, consumer savings reached record levels. The increase in consumer savings has served to push up prices, as consumers have (or at least had) greater disposable income thanks to lockdown savings. Additionally, businesses also wanted to compensate for their loss of revenue during Covid, with many increasing their prices to compensate.
Another reason is China’s Zero-Covid strategy. China plays an important role in the global economy due to its ability to produce quality products at a low cost. However, China is regularly implementing lockdowns in important trade cities in order to maintain its Zero-Covid approach. As a result, prices have increased due to the uncertainty and disruption to global supply chains. For firms that import goods from China, this means they have decreased supply of stock. Therefore, prices have increased in the face of decreased supply and high consumer demand.
Furthermore, the ongoing war between Ukraine and Russia has had a major impact on inflation. Russia is a major supplier of oil, gas, and metals, and, together with Ukraine, of wheat and corn. Oil plays an important role in the global economy, ranging from the transport of people and consumer products to the manufacturing of such products. The war’s impact on the supply of gas and oil has seen particular increases in the cost of energy, with energy prices rising by more than 25%.
Why isn’t this high inflation stopped/reduced?
The European Central Bank aims to keep inflation in the Euro Area below, but close to, 2%. This is seen as the optimal rate for promoting growth and employment while ensuring the economy does not overheat. Obviously, the current rate of inflation is far from the ideal, but what can be done to stop it?
So far there has been a reluctance to take steps to slow inflation on the part of the ECB, although they have indicated that later this year interest rates will increase. Interest rates are one of the primary tools at the disposal of central banks when tackling high inflation. Increased interest rates constrain consumer and government spending as the cost of borrowing rises.
This in itself will have a substantial impact on the Irish economy. The Irish government have, for the last while, enjoyed negative interest rates on Government borrowing; meaning lenders paid the Irish government to hold their money. This allowed governments to borrow unprecedented sums of money at historically cheap rates in order to fund the huge expenditure throughout the pandemic. However, the cost of borrowing for the government is rising. This will have considerable effects on government spending, particularly in relation to capital projects such as the construction of infrastructure and social housing, as the cost of funding these long-term projects rises considerably.
Inflation is necessary for a functioning economy, however, the current rates being experienced go beyond what is economically healthy. No doubt readers will have noticed and experienced the effects of inflation first-hand over the last few months, with noticeable price increases across almost all consumer goods and services. However, unfortunately, there is no easy fix to the current levels of high inflation. The go-to-move of interest rate hikes will also have noticeable effects on businesses and consumers alike, now and into the future.
Wilson Tai – Business Writer
Additional Reporting: Mark O’Rourke – Business Correspondent