Investors’ main focus this week is on the personal consumption expenditure index. And the reasons for them are clear: this economic indicator demonstrates the level of inflation. Many of us – even those who have no trading experience – have heard that inflation is bad. But what does this economic indicator actually mean?

Inflation is a sustained increase in the prices of goods and services over a certain period. In the United States, for the period from 1914 to 2022, it averaged 3.27% per annum. Thus, moderate inflation has been an integral part of life and a normal economic condition for more than a century.

However, it is important to distinguish between the effects of normal inflation and excessively high ones. In this article, we’ll look at the key effects of inflation on consumers, investors and the economy as a whole, with a particular focus on the negative aspects that arise when prices spike.

Causes of inflation

Inflation is an increase in the prices of goods and services over a period of time. It reduces the purchasing power of people, devaluing the amount of their income. A little inflation is not a problem, but a sharp rise in prices can have serious consequences.

What factors lead to inflation?

  • Imbalance of supply and demand: Inflation increases when demand for goods and services exceeds supply.
  • Supply disruptions: For example, a pandemic or military conflicts can disrupt supply chains, causing prices to rise.
  • Inflation expectations: People who expect prices to rise demand higher wages. This leads to increased costs for businesses, which, in turn, increase prices for their products.

1. Inflation reduces purchasing power

The main effect of inflation is a decrease in the purchasing power of consumers. Over time, prices for goods and services rise, and a fixed amount of money allows you to buy fewer products than before. In terms of long-term consequences, prices will rise faster than incomes, leading to a significant decrease in purchasing power.

Typically, inflation is measured by two indicators – the consumer price index (CPI) and the personal consumption price index (PCE).

2. Inflation affects low-income consumers

People with low incomes are more vulnerable to inflation than those with higher incomes because they spend more of their budget on essentials such as food and energy. Prices for these items are rising faster than others, which reduces the purchasing power of low-income people. Core inflation does not take into account food and energy prices, so it does not reflect the true impact of inflation on low-income people. Policymakers and market participants should take this issue into account when developing their solutions.

3. High inflation tends to run out of control

Minor inflation typically signals healthy economic dynamics without causing higher inflation expectations. If the inflation rate for last year was 2%, and this year remains at the same level, such fluctuations can be considered background noise. In this situation, businesses, workers and consumers will most likely assume that inflation will remain at 2% next year.

However, when inflation accelerates sharply and remains high, it causes inflation expectations to rise. As they increase, workers begin to demand larger wage increases, and employers pass these costs on to consumers by increasing the prices of goods and services. This starts a spiral of wages and prices, where rising wages increase costs for businesses, and rising prices, in turn, lead to further increases in inflation.

4. Against the backdrop of inflation, interest rates rise

These examples illustrate that governments and central banks have good reasons for controlling inflation. If inflation threatens to exceed the central bank’s target (usually 2% in developed countries and 3-4% in developing countries), an increase in the minimum interest rate is applied. This causes borrowing costs to rise throughout the economy, limiting the money supply.

As a result, inflation and interest rates tend to move in the same direction. Raising rates when inflation rises allows central banks to curb economic activity, reduce risk appetite and, as a result, price pressure.