A ghost is haunting the world—the ghost of inflation. The sustained rise in prices of everyday goods and services in the last two years—the global inflation rate was close to 9% in 2022—has kept policymakers and central bankers up at night. Every tool at their disposal—-primarily interest rate hikes—was deployed to rein in this economic phenomenon that has been squarely blamed for slowing global GDP growth.
Yes, high inflation erodes the purchasing power of money and hurts the value of your savings. But, is inflation always the villain as it is painted to be? Will the absence of inflation by default boost economic growth? Or, does inflation have multiple facets? To answer these questions, we need to thoroughly understand inflation and more importantly, its innocent-sounding cousin, deflation.
What is inflation?
Inflation measures the rise in prices in an economy, best experienced while tanking up at the petrol pump or buying your monthly grocery.
Some economists think that inflation is the result of the increase in the amount of money in circulation relative to the supply of goods. In economic terms, inflation is a function of the supply and demand of money. In other words, printing more currency notes will decrease the value of each rupee, forcing the general price to rise. Yet, there is more to inflation as we will find out.
Pressure on the supply side or the demand side in the economy can create inflation. Supply shocks that disrupt the production process such as natural disasters, or push up production costs such as a rise in crude oil prices can reduce the supply of goods, leading to cost-push inflation. The rise in tomato prices in India last month is a classic example of cost-push inflation.
Conversely, demand shocks, such as stock market rallies, central banks cutting interest rates, or increased government spending can temporarily boost overall demand and economic growth. More demand for goods and services that exceeds the production capacity of the economy in the short run, fuels demand-driven inflation.
This article will focus solely on inflation that results from the supply and demand of money in the economy. Read on to learn how it can make or break an economy.
Central banks keep inflation balanced
Milton Friedman famously said inflation is caused by too much money chasing too few goods, pointing to the supply of money in the economy. Central banks control the circulation of money in an economy, and hence too much money supply results from a loose monetary policy. A central bank’s job is to maintain the optimal supply of money that is just a little above the demand for money in the economy.
The Monetary Policy Committee (MPC) of the RBI in its October 2023 meeting observed that “Inflation has moderated from its July peak, bolstering macroeconomic fundamentals.” The statement makes it clear that controlled moderate inflation will boost India’s economic growth.
Meanwhile, in the most recent US Fed meeting held in November 2023, the Board of Governors of the Federal Reserve System voted unanimously to approve the establishment of the primary credit rate at the existing level of 5.5 percent as inflation remains elevated. However, the Fed did not cut rates as it thinks inflation is still high.
While keeping inflation low is their mandate, it is to be noted that neither the RBI nor the Federal Reserve has talked about bringing inflation down to zero. For India, the medium-term inflation target is 4% with a tolerance limit of +/- 2%. For the US, the inflation target is 2%. In other words, the idea is to maintain a planned, controlled price rise in the economy.
Therefore, it follows that low, stable, and predictable inflation is good for an economy. The predictability factor makes it easier to capture it in price-adjustment contracts and interest rates, reducing its distortionary impact.
A healthy dose of inflation is good
Inflation, we know, is a situation where consumer prices are rising. But if people buy less and save more, it will reduce aggregate demand, leading to less production, layoffs, and a faltering economy. Thus, too much savings and too little inflation can also hurt economic growth, a phenomenon British economist John Maynard Keynes called the paradox of thrift.
Thus, it follows that an increase in consumer prices isn’t always a bad thing. While rising production costs push up the prices of goods over time, the increase in household income balances it out.
Everything in moderation is good, even inflation. In fact, it creates a win-win situation for all stakeholders in an economy—businesses invest more to meet increasing demand, wages rise, consumers buy more, and overall employment rises. The cycle continues. More jobs lead to higher earnings, resulting in more spending, increasing the demand for goods and services, and thus contributing to overall economic growth.
What is deflation?
Deflation—a decrease in consumer and asset prices—is widely understood as the exact opposite of inflation. Sounds good, right? But it is not, as we will find out in a bit.
While it may sound beneficial, persistent deflation signals weak economic growth and can lead to a recession. Ideally, declining prices should be good news for consumers as they will be able to buy more with less. Well, not exactly. In a situation of falling prices, people postpone spending hoping to buy goods at an even cheaper price in the near future.
Falling demand will force businesses to cut production, leading to unemployment and further fall in prices. If this cycle is prolonged, it is likely to lead to a recession or a fall in economic activity.
Truth be told, an economy in deflation is as risky as an economy facing sky-high inflation. Japan, the world’s third-largest economy, is a case in point.
How persistently low inflation set Japan back for decades
Japan endured economic stagnation and deflationary pressures for almost three decades beginning in the 90s. The Bank of Japan has a single mandate — to ensure sustainable price stability. The BOJ has adopted a “super” accommodative economic policy with negative short-term interest rates and limits on longer-term rates.
Japan officially declared a state of deflation in 2001. The Japanese government and the BOJ have made preventing price falls their policy priority. The government launched a big fiscal spending program to rev up the economy for many years. Additionally, the BOJ has been under pressure to maintain ultra-low interest rates.
An example of BOJ’s policy response to boost inflation is negative interest rates. The BOJ in a bid to reinflate the economy first adopted the negative interest rate policy in February 2016. To spur credit creation, the bank imposed a rate of negative 0.1% on excess reserves that financial institutions place with the central bank. This effectively meant the central bank was charging commercial banks for deposits.
Japan’s three-decades-long battle against deflation appears to have borne fruit at last. Japan’s core inflation hit a four-decade high of 4.2% in January 2023 and remained above the BOJ’s 2% target for 16 straight months in July, as more firms pass on higher raw material costs along to consumers. In addition, companies offered their highest pay hikes in three decades in 2023. The pay rise is an impact of a steady price rise in the economy,
Despite favorable inflation numbers, the Japanese government has refrained from officially declaring an end to deflation, arguing that doing so requires not just underlying price rises but clear signs that Japan won’t return to periods of price falls. The government thinks that the entrenched deflationary mindset of households and companies needs to change before it can officially declare an end to deflation.
Inflation as a barometer of economic health
Japan’s example demonstrates how deflation can set an economy back for decades together. To use an everyday analogy, inflation is the blood pressure of an economy. Just like you need to maintain a level of blood pressure to be alive, an economy needs a certain amount of inflation to grow. Too much inflation, like hypertension, can prove fatal for the health of an economy. At the same time, deflation, like low blood pressure, can lead to economic stagnation.