Inflation

Inflation is a significant factor in the economy and plays an important role in fundamental analysis. Let's take a closer look at what inflation, hyperinflation, and deflation really mean.

As mentioned in the previous lesson, central banks face a challenging task of balancing. Most of them have a dual mandate – to ensure high employment while keeping prices stable. To maintain price stability, it is essential to control inflation.

What is inflation?

Inflation is the process by which prices in the economy rise over time. The term is named for the fact that prices gradually "inflate" higher, much like a balloon being blown into the air.

Although rising prices may seem negative, it is a natural part of a growing economy. Most economists today believe that moderate and stable inflation can help mitigate the effects of an economic crisis, as it provides a kind of cushion against falling prices, which can become problematic if deeply entrenched.

Therefore, central banks strive to keep inflation within reasonable bounds. For example, the Bank of England targets an inflation rate of 2%. This means that prices should rise by 2% every year.

If inflation falls below 2%, the bank may lower interest rates to stimulate the economy and help it get back on track. If inflation rises too much, they may raise interest rates to slow down economic growth. Otherwise, they could face the risk of hyperinflation.

Hyperinflation

Hyperinflation occurs when inflation completely spirals out of control. Prices become extremely high, and the value of the currency dramatically falls. Notable examples of hyperinflation include Germany before World War II, Russia after the collapse of the Soviet Union, and Zimbabwe in the mid-21st century.

Hyperinflation often leads to a complete loss of confidence in the economy and its currency, causing serious problems. This is why central banks constantly monitor the economy and take measures to avoid such a catastrophic situation. Some analysts argue that the increased use of unconventional monetary policies, such as quantitative easing, since 2010 could potentially lead to hyperinflation, as such actions could flood the markets with a large amount of capital.

Deflation

Deflation occurs when prices fall, meaning inflation is below 0%.

For the average person, deflation may seem like a positive thing. Who wouldn’t want the goods they buy every day to be cheaper?

However, manufacturers and business owners see it differently. Deflation means a reduction in the margins they earn from sales, which impacts their profits and can lead to layoffs. As unemployment rises, demand for goods declines, and services are even more affected. What does this lead to? Further job losses.

This process is called a deflationary spiral.

To prevent this spiral, central banks may consider easing monetary policy if inflation falls.

Reflation and disinflation

These terms describe changes in the rate of inflation:

Reflation occurs when the inflation rate rises.

Disinflation, on the other hand, happens when the inflation rate falls.

In the 1990s and 21st century, the Bank of Japan attempted to reverse the persistent deflationary trend. During this period, inflation remained low, and the economy experienced stagnation, leading to a period known as the "lost decades."

Low interest rates (0%) failed to stimulate consumer spending or business activity. Eventually, the Bank of Japan turned to quantitative easing, where the central bank purchased bonds and asset-backed securities to increase the money supply and stimulate inflation.