Abstract:

• Inflation is an economic/monetary phenomenon that, in layman’s terms, means money supply increases, things become more and more expensive, and money can buy less and less.
• Inflation has various causes and different theoretical explanations, such as the quantity theory of money, Keynesian theory, etc. Since the formation of inflation is very complex, the choice of theory needs to be based on specific situations.
• Different countries face different degrees and types of inflation problems at different times, and need to formulate corresponding policies according to their own economic situation and goals.

What is Inflation?

Inflation is an economic/monetary phenomenon that, in layman’s terms, means money supply increases, things become more and more expensive, and money can buy less and less. For example, 10 years ago you could buy a piece of clothing with $100, but now you might need $200 to buy the same piece of clothing. This means that the same amount of money has lost its purchasing power, and the price level has risen.

Inflation is an economic/monetary phenomenon that, in layman’s terms, means money supply increases, things become more and more expensive, and money can buy less and less. To put it more rigorously, inflation refers to a persistent rise in the overall price level of an economy over a period of time, or a persistent decline in the purchasing power of equivalent money. The price level is the average price of a set of representative goods or services, which can be measured by various price indices. Therefore, the inflation rate is the percentage increase in the price level, which is the most intuitive indicator of the degree of inflation.

Monetarism explains inflation as a result of an increase in money supply that exceeds economic growth, that is, the government issued too much money, which led to a decline in the purchasing power of the issued money, and then price increases.

Neo-Keynesian economics argues that inflation is mainly caused by the interaction between money, interest rates and output. When the economy is in a situation of high demand and low supply, prices will rise; otherwise they will fall.

Supply-side economics argues that inflation is caused by rising production costs, that is, when the cost prices of raw materials rise, producers have to raise the prices of goods and services to maintain profits, which leads to price increases.

There are also other theories such as “demand-pull inflation”, “imported inflation”, etc. Different theories usually go back to the balance of supply and demand relations, but different theories have different explanations for the origin of inflation, and thus have different perspectives on observation and control.

The relationship between inflation and the economy

The relationship between inflation and the economy is not a simple positive or negative effect, but depends on the degree, cause and expectation of inflation.

Generally speaking, low and stable inflation may be conducive to economic growth and employment. This is because low and stable inflation can reflect positive factors such as strong demand, increased output, technological progress, etc., and can also stimulate consumers and businesses to consume and invest ahead of time to avoid higher prices in the future. In addition, low and stable inflation can also avoid the dangers of deflation (i.e., price declines), such as reducing real debt, delaying consumption and investment, reducing profits and income, etc.

However, high and unstable inflation is detrimental to economic growth. This is because high and unstable inflation can reflect negative factors such as insufficient supply, rising costs, policy failures, etc., as well as undermine consumer and business confidence, create market chaos and reduce efficiency. In addition, high and unstable inflation also affects the functions of money (medium of exchange, unit of account, store of value).

How to observe inflation

There are various indicators to observe how much inflation there is. They can reflect different price changes and impacts. Here are some commonly used indicators:

• Consumer Price Index (CPI): measures the price changes of a set of representative consumer goods and services. It reflects consumers’ living costs and purchasing power. CPI is the most common indicator of inflation. It is also a reference for many countries to formulate monetary policy and adjust social welfare. The composition of CPI varies from country to country or region. For example: In America: CPI consists mainly of seven categories: food and beverages; housing; apparel; medical care; transportation; education; recreation; etc., among which housing accounts for the highest proportion: about 40%.
• Producer Price Index (PPI): measures the price changes of raw materials and intermediate goods purchased by producers. It reflects production costs and profits. PPI is an important indicator for predicting future CPI changes. It is also an important indicator for measuring supply-side pressures. Similarly: The index composition varies from country to country, but usually includes: raw material prices; energy prices; intermediate product prices; labor costs; transportation costs; taxes and fees; etc.
• GDP deflator: measures the price changes of all goods and services in the gross domestic product (GDP). It reflects the overall price level of a country. GDP deflator is the most comprehensive indicator of inflation. It is also an important indicator for comparing the economic size and growth rate of different countries.

Observing inflation not only requires looking at the numbers, but also the underlying causes and impacts. Different inflation indicators may have different trends and fluctuations, and need to be interpreted and judged reasonably according to different situations. For example:

• CPI may be affected by seasonal factors, structural factors, policy factors, etc., resulting in short-term fluctuations in rising or falling, but not necessarily representing the long-term trend of inflation. In addition, the categories and weights of CPI are adjusted: For example, the U.S. government added goods and services items in 1995 and 1996; the U.S. Department of Labor usually adjusts the weights of CPI every two years, and will start to adjust them annually from January 2023.
• PPI may be affected by international markets, exchange rates, supply and demand relations, etc., resulting in a certain time lag and transmission effect with CPI, but not necessarily fully passed on to the final consumers.
• GDP deflator may be affected by new products, technological progress, quality improvement, etc., resulting in some differences and deviations with CPI and PPI, but not necessarily reflecting the actual price changes.

Japan and the U.S.

Different countries may face different degrees and types of inflation problems at different times, and need to formulate corresponding policies according to their own economic situation and goals. Here are two representative examples:

Japan wants to raise inflation because it has been in a situation of deflation and economic stagnation for a long time. Since the bubble economy crisis broke out in the 1990s, Japan has fallen into a vicious cycle of low growth, low interest rates, low prices, and high debt. Consumers and businesses lack confidence and motivation, and economic vitality is insufficient. In order to break this situation, Japan’s central bank implemented ultra-loose monetary policy, greatly increasing money supply, lowering interest rates, and even implementing negative interest rate policy. It also set a 2% inflation target, hoping to stimulate demand, raise prices, increase income, and promote economic recovery. For more information on Japan’s economic past, please refer to our previous article “Japan’s Central Bank Policy and the Lost Thirty Years”.

And recently the United States is trying hard to lower inflation due to the impact of the COVID epidemic and supply chain problems. Since the outbreak of the COVID epidemic in 2020: The U.S. government and central bank have implemented large-scale fiscal stimulus and quantitative easing policies.

However: In 2021: As vaccination and economic reopening progressed: Demand rebounded rapidly: But supply was constrained by factors such as raw material shortages: Transportation barriers: Labor shortages: Etc.: Leading to supply-demand imbalance and cost increases: Prices rose at their highest rate in years. The Fed’s interest rate hike is based on monetarism’s perspective on controlling inflation.

Investment ideas and suggestions

The Fed’s interest rate has reached a phased peak: And is expected to remain high for a period of time: The current uncertainty continues. We recommend investors to take defensive investment as the main axis in the current situation:

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