In economics, inflation refers to a general progressive increase in the prices of goods and services in the market. When the general price level of goods or services rises, each unit of currency buys fewer goods and services. Consequently, inflation corresponds to a reduction in the purchasing power of money.

There are various factors that can drive prices or inflation in an economy. Typically, inflation results from an increase in production costs or an increase in demand for products and services.

How To Measure The Rate of Inflation

Governments, represented by Office for National Statistics in some countries around the world, measure the rate of inflation every month by checking the prices of a whole range of items in a basket of goods and services. For instance, the government records the cost of over 700 products and services that consumers regularly purchase. The basket includes products that consumers buy every day, such as bread and a bus ticket. It also includes much larger products, like a car or holiday expenses. 

The price of that basket tells us the overall price level, which is known as the Consumer Prices Index CPI. To calculate the rate of inflation, governments compare the cost of the basket or the level of the Consumer Prices Index with what it was a year ago. The change in the price level over the year is the rate of inflation.

What Central Banks Do To Keep Inflation Stable

The Central Banks around the world have the duty of setting monetary policy to keep inflation level low and stable. The main way Central Banks do that is through interest rates. An interest rate is the amount of money people get on any savings they have. It’s also the charge they need to pay on their loans and mortgages. 

So the link between the interest rates and inflation is that higher interest rates make it more expensive for people to borrow money, but encourage them to save instead. That means that overall, they will tend to spend less. Therefore, if people on the whole spend less on goods and services, prices will tend to rise more slowly. That lowers the rate of inflation.

On the opposite side is the Central Banks lowering interest rates, which means it’s cheaper to borrow money, and there’s less incentive to save. This encourages people to spend, which automatically will increase the rate of inflation. 

In some cases, the Central Banks will be forced to stabilize or reduce the negative impact on the economy, during for instance, crises such as COVID-19. Therefore, Central Banks influence interest rates by making it either cheaper or more expensive to borrow money and by making it more or less attractive to save. By doing so, Central Banks influence interest rates in two main ways.

1. Set bank rate, often referred to as the base rate. This is the single most important interest rate in the global market, as it influences all other interest rates. 
2. To influence interest rates, Central Banks can buy and sell bonds, mainly government bonds, from and to financial markets. Buying assets in this way is called Quantitative Easing QE. Through Quantitative Easing enables Central Banks to influence the interest rates on savings and loans. For instance, to reduce the impact of COVID-19 pandemic on the economy, the United States Federal Reserve announced on March 15, 2020, that they would start purchasing 700 billion USD worth of government debt bonds and mortgage-backed securities from domestic financial institutions.

Unfortunately, these two steps would heighten the inflation rate, which happened at the beginning of 2022. To reduce the rate of inflation, the Federal Reserve, on March 17, 2022, announced the first interest rate increase in more than three years to address spiraling inflation without torpedoing economic growth.

After keeping its benchmark interest rate anchored near zero since the beginning of the COVID-19, the policymaking Federal Open Market Committee said it would raise rates by a quarter percentage point, or 25 basis points.

The interest rate into a range of 0.25 percent to 0.5 percent. The move will correspond with a hike in the prime rate and immediately send higher finance costs for many consumer borrowing and credit forms. 

What is High or Low Inflation

Many Central Banks have chosen a common policy of an inflation target near two percent. These Central Banks include the Federal Reserve, the European Central Bank, and most other Central Banks in advanced economies; choice to have a healthy economy needs to have a low and stable rate of inflation. 

A little high or low of inflation is helpful. But higher and unstable rates of inflation can be harmful.

Because if prices are unpredictable, it is difficult for people to plan how much they can spend, save or invest.

Some researchers argue that a two percent inflation target is too low. It is not clear what target is ideal, but four percent is a reasonable guess, in part because some countries, such as the United States, have lived comfortably with that inflation rate in the past. If Central Banks raise their inflation targets from two to four percent, the economic benefits will exceed the costs.

The primary reason to raise inflation targets is to ease the zero-bound problem. The constraint on monetary policy arises from the fact that nominal interest rates cannot be negative. A higher inflation target raises the long-run levels of nominal rates, allowing larger decreases in rates before the zero bound becomes binding. This flexibility makes it easier for Central Banks to restore full employment when an economic slump occurs. 

In the United States, a four percent inflation target would have dampened the Great Recession of 2008-09, when interest rates hit the zero bound. The researchers further argued that four percent inflation would keep interest rates away from zero during future recessions. The argument is that the benefits to the economy would be substantial, based partly on the behavior of interest rates during past recessions. 

In contrast, the costs of four percent inflation are small. Neither history nor evidence from research suggests that an economy’s efficiency is significantly lower with four percent inflation than with two percent. 

Historically, there were three recessions that began with the inflation rate between two and three percent. These episodes provide the most direct evidence on the zero-bound problem at low inflation rates. 

One of the three is the Great Recession of 2008-09, when the federal funds rate hit the zero bound. The other two are the first recession, which occurred in 1960- 61, and the last one before the Great Recession, in 2001. 

In addition to low inflation, the recessions of 1960-61 and 2001 have two noteworthy features. First, they were mild recessions: their unemployment peaks of 7.1 percent and 6.3 percent are two of the three lowest. 

Second, the federal funds rate did not hit the zero bound, but it came close. The nominal funds rate fell to 1.2 percent following the 1960-61 recession and 1.0 percent following the 2001 recession. In the latter case, when the funds rate reached 1.0 percent in 2003, many economists thought it might fall farther if the economy remained weak. 

Some Central Banks acknowledge that 4 percent inflation does not greatly harm the economy. Why then do they oppose an increase from 2 percent to 4 percent? Some argue that a decision to accept 4 percent inflation may actually cause inflation to rise above 4 percent, or at least create expectations of that outcome. 

What Are The Effect of High Inflation on Consumers

As we mentioned earlier, high inflation is when prices for goods and items are unusually high, which leads the consumers to get less for their money when purchasing goods or services.

Although a 2 percent rate of inflation can be positive, it can also damage individual finances, depending on the circumstances.

High inflation erodes the average person’s purchasing power. Each individual has a different true inflation rate, as we all buy different products and services. An individual can expect to pay higher more for products, such as cars and car rentals, furniture, airline fares, hotels, and everyday essentials like groceries and gas, than last year. 

All of these means individual paycheck is not going as far as it once did unless the wages are increased at the same pace, which has not been the case for most individuals.

High inflation is also generally bad for savers, as low-interest rates combined with rising inflation means that there is less chance of seeing a return on money in savings accounts.

Usually, interest rates on savings accounts are decreased to around zero percent during high inflation, which makes your cash worth even less. That’s doesn’t mean we should not save, as savings are not designed to make you rich. It’s meant to provide a financial cushion, should you need it.

However, if you have more saved cash than you need in an emergency fund, above what experts recommend having three to six months’ worth of expenses saved, then you might consider investing. 

What Are The Effect Of Inflation On Investments

It’s difficult to predict how inflation will affect some investments. Investors who are investing in some retirement plan, such as 401(k) or IRA, or who are already invested in a target-date fund or other stock index fund should remain calm and don’t need to do anything. However, some investors must be aware that in some investments, such as bonds, the high inflation rates decrease the value of long-term bond investments, which generally pay a fixed income amount every year. Higher inflation means that a fixed amount doesn’t go as far. Investors investing in valued stocks should be fine sticking with their current investment. Stocks can provide a decent hedge against inflation, because they can generate returns in excess of inflation.

Therefore, long-term investors should continue investing in a broadly diversified low-cost stock index funds portfolio. 

Investors must hold assets in particular companies, for example, energy companies, that might see a rise in their stock prices if product prices are rising.

Some companies have the ability to reap the rewards of inflation by charging more for their products as a result of a surge in demand for their goods. In other words, inflation can provide businesses with pricing power and increase their profit margins. If profit margins are rising, the prices that companies charge for their products are increasing faster than increases in production costs. Also, businesses in deliberate moves can withhold supplies from the market, allowing prices to rise in their favor. 

Investors must bear in mind that, however, some companies can be hurt by high inflation if the inflation is caused as the result of a surge in production costs. Some companies are at risk if they’re unable to pass on the higher costs to consumers through higher prices. If foreign competition, for example, is unaffected by the production cost increases, their prices wouldn’t need to rise. As a result, companies stationed in the United States, for instance, might have to eat the higher production costs; otherwise, they risk losing customers to foreign-based companies.

To learn more about how to invest during high inflation period, you can purchase THE FIRST INVESTOR book and receive a discount by clicking on The First Investor.