Because there are so many topics that influences inflation, it is easier to understand it using a diagram.
The below is a very, VERY quick diagram, with a focus on our current situation.
The yellow blocks represent actions that can be taken to change the rate of inflation.
The blue blocks represent events that change the price levels in the economy. They are influenced by regulatory and other action, but typically with a time delay. And sometimes the short and long term effects of an intervention are opposite to each other. And frequently a action can have two side effects, one counter-acting the other.
The red blocks are major external influences or results, over which there is no control.
At the moment, summer 2022 in the northern hemisphere, the USA and Europe are struggling with inflation that is too high. Now first question is, what is the cause of this inflation. Is it
A lot of the complaints are about the high energy costs, which is mostly due to the war in the Ukraine. (Yes there was also rising post-pandemic demand, but the biggest share comes from the war.)
Another major driver of price increases are the effects from the pandemic. This is two fold. As the economies are re-opening, demand is quickly exceeding the shuttered supply, as well as the shuttered supply chain infrastructure.
Finally, the assistance provided to people during the pandemic in many different government assistance programs led to a large amount of money coming into the system. Whether it was too much or too little is hotly debated, and heavily influenced by your political affiliation. What is true, is that for once the assistance actually went to the people that needed it, not to the banks and already rich people.
The tools that are available are as follows:
The reserve banks can increase interest rates.
This would be helpful in mopping up excess cash in the economy, by making it more expensive to borrow. This leads to lower demand, which, theoretically*, leads to lower prices. BUT, it also leads to a stronger currency, which increases imported costs, which increases inflation.
The government can raise tax rates.
Raising tax rates will also reduce the available cash in the market. However, the effect of tax changes are extremely slow. Tax rates are set a year in advance, so will only have effect in the next fiscal year. But at the moment, at least in the USA, and the UK, there are structural problems with tax rates - they are too low. So this probably should be done, but, EXTREMELY IMPORTANT, in the correct tax brackets.
The government can regard the energy crisis/ inflation as a disaster situation, and therefor provide assistance to the consumer. It addresses the symptoms, but not the causes of the problem. IF this is accompanied by a windfall tax on energy companies’ profit, it might be a reasonable short term idea.
It is clear that not one of the above interventions are going to address two major causes - high energy prices, and the disrupted supply chains. In a capitalist society, there is very little that a government can do about this.
Oil and gas companies, keeping in mind the coming switch to green energy, are refusing to invest in higher production, even at record price levels. Instead, the record profits are returned to shareholders in buy backs. Which increases share prices, and executive bonuses.
What governments are doing, is upgrading infrastructure, and promoting renewable energy generation. Both of these are long-term investments, that will have a positive impact only in several year’s time. But let’s seize the opportunity to get the work done, which has been delayed for too long. In the short term though, the increase in demand caused by these investments, may very well slightly increase inflation.
In the USA, the Biden administration has taken steps to improve the situation in the supply chains. This has led to major improvements. But which have been offset by further pandemic related disruptions in China.
What will be the follow on effects?
In the USA, increases in interest rates are somewhat muted, because mortgage rates are typically fixed. it is only new loans that are affected by the increase in interest rates. In South Africa on the other hand, mortgage rate float, and any increase in the rate by the reserve bank, will immediately (few days) lead to a rise in mortgage payments. This, working in tandem with general inflation, may theoretically* lead to a push for higher wages.
However, the dollar is sharply strengthening against other major currency, which will be inflationary.
Production costs will increase because of the increased import cost, higher interest costs and higher energy costs. If producers, and wage earners, start believing that these price increases will remain for a long period, they will start anticipating this in their supply and wage contracts. This is the great fear of reserve banks everywhere, and why they are quick to start fighting inflation with higher rates.
IF the rates increases are too high, it could lead to a spiral of declining demand, labor retrenchments and declining profits, which may very well end in a recession or worse.
So far I have been talking about consumer prices. But another major part of the equation, is asset prices, mostly those of bonds(loans), property and shares. And in this area, black magic happens, largely due to the large traders and hedge funds. Accepted wisdom is that when share prices decline, or are expected to decline, investors will sell shares, and buy bonds. and vice versa. The key phrase here are “expectation” and different investors have different expectations. Until they suddenly no longer have different expectations.
When everybody suddenly has the same negative expectation, things happen very quickly and very badly. Think of the stock market crashes in history - 1929, 1987, 2000, 2008 and .... Notice how they are getting closer and closer to each other.... (To be honest, the source I got these dates from have left out a few corrections.) All serious market investors, i.e. the one not on the television shows, are anticipating a major correction in the near future.
The reasons are basic, the world economy is sitting on unprecedented debt levels. In previous recent corrections, the USA Federal Reserve and most recently in 2009 the European Reserve, have avoided addressing the issues of excess debt. In fact they addressed the symptoms of the problem and rather increased the debt. Which will just make the reckoning worse.
If the market suddenly aligns behind the perception that the interest rates have been increased too high, that demand will decrease too much, they will move their trillions of investments from shares to bonds, then shares will nosedive. Again. Companies will retrench again. and panic will ensue. The question then becomes - will the reserve banks blink and start increasing liquidity, or will they stand fast and drain the debt? Nobody knows. However, if they do blink, they will just postpone the inevitable. We are living on the earnings of our children. And demographic are not on our side. At least not in the USA and Europe.
One last comment on assets, asset inflation and interest rate levels. In general, interest rates are “supposed” to be above the inflation rate. This has not been the case in the USA for a very long time. And in the past, inflation above 5% have NEVER been reversed before interest rates have exceeded the inflation rate. Bear in mind that the inflation rate is currently above 8%.
The digression into asset inflation was just to show that there is an extremely high likelihood of a severe recession in the next 6-18 months. If this does not happen, GDP growth will continue to be sluggish in the next cycle. And the next, until the debt problem has been addressed. (The next topic that I will write about is “The problem with GDP”. In short, GDO is a bad approximation for economic growth. Military expenditure and waster is considered as valuable as food production.)
This is a very high level overview, with many aspect (e.g. factory utilisation and inherent economic growth limits) left unaddressed. So yes, there are a lot in the aforementioned that can be debates.
I hope though that you will have a slightly improved understanding of the difficult position that the world and its leaders are in at the moment. There are no easy answers, even less so than before. War, pandemics and climate change is an unholy trinity of the worst magnitude.
My personal thoughts are that the interest rates are not the correct medicine for the current inflation problems, as excess liquidity is a small part of the problem. But they are the correct medicine for the excess debt levels in the world economies.
However, that will most probably lead to a severe recession relatively soon.
What can you do about it?
The short answer is the same as in all stages of the economic cycle. Live within your means. Do not have consumer debt. Only have investment/ production debt that is safely repayable, even if your investment/ business income falls dramatically.
*theoretically - Price reduction due to competition for a drop in demand, only works if there is actually competition in the market. But when one infant milk bottler controls 50% of the market, when there are only a handful of cellphone makers, no meaningful competition in any Internet Service Provider market, etc, there is no incentive for suppliers to reduce prices, buyers have nowhere else to go. But this is a different topic, for a different day.
This logic applies in exactly the same way to wage prices - there are a limited number of employers, and, especially in the USA, a severe curtailment on the ability of employees to bargain for higher wages or to change employers. This happens through restrictions on unionization, and the excessive use of restraint of trade agreements.