Why does High Inflation hurt the Economy?

We are talking about one of the most important market movers that we find within the context of investments and financial markets in general.

Inflation, seen as an economic indicator and not as simple data, tells us a lot about the state of health and tension within a specific economic area. An analysis of the causes of high inflation can help us understand why it should fall to levels that are considered by central banks as "acceptable".

The role of inflation within the economy is equal only to that of interest rates, another economic factor whose importance is slightly higher than inflation as a regulator of the same in the long run. At this historic moment we see generally high inflation in all western economic areas, especially in the USA and Europe, economic areas of enormous importance within the dynamics of the financial markets. For this reason, an analysis of inflation is necessary to understand what the future could be, not only for the markets, but also for the real economy of these areas.

The inflation target

As already mentioned, interest rates and inflation are macroeconomic factors that go hand in hand in order of importance. One influences the other, therefore the central banks, the institutions that establish the level of the interest rate, observe inflation in order to adjust what is precisely defined as "the cost of money".

Central banks set a inflation target, i.e. a target level that they deem optimal for controlling healthy growth and balance within the economic area. For example, the ECB and the Fed have “inflation target” 2%. The ideal situation for a central bank is to see an inflation rate that remains slightly below and close to 2% for a long time.

If inflation falls too far below 2%, or above it, the central bank will be forced to intervene to adjust this inflation by means of interest rates. The higher inflation rises, the higher the cost of money must be, the lower inflation falls, the lower the interest rate must be.

A high interest rate causes the economy to stop and consequently inflation to fall, conversely a low interest rate causes the economy to expand and inflation to rise. The current situation sees inflation well above 2%, so there is a lot of tension with central banks about containing prices. Thus, central banks push interest rates to high levels with direct consequences within the economic and financial circuit, trying to bring inflation towards the 2% target.

Why inflation is too high

The causes are mainly two. The first relates to a long period of maintenance of interest rates close to 0%. This has led to huge amounts of liquidity within the financial system - the credit system - without fueling demand. In practice, the price increase was not seen for a long time due to the increase in credit which literally "spread" the price increase only at the end of the expiry date.

For example, buying a car on installments is economically different from buying a car without credit. For the dealer, in the first case, a credit is generated and the entire price of the car is spread over time, while in the second case, the dealer collects the entire price of the car immediately. The effect on prices is markedly different as the purchaser’s outlay is deferred over time. This leads the inflation rate to remain around 0%, with a strong danger of seeing deflation in the long run.

Central banks continued to maintain this low rate policy until a “black swan” style event triggered the sharp rise in inflation and which is at the same time the second cause of this rise. We are talking about the consequences of the pandemic within global exchanges and the blockage of the supply chain, that commercial chain that brings supply and demand to meet. A period of blockage in the transport of goods is enough to create panic within the economy. A lack of components, raw materials and products has led to a lack of supply, which has led to prices almost inevitably rising. If inflation normally rises due to growing demand, this time it rises due to a lack of supply, a completely anomalous situation at an economic level.

What needs to happen

Central banks have already raised rates but inflation continues to remain high due to the fact that consumption has recovered after the pandemic. The problem is the erosion of consumption, ie the situation in which consumers now pay higher prices than before and therefore find themselves forced to pay more to maintain the same lifestyle.

The increase in rates serves precisely to discourage consumers from opening credit lines, which are more expensive, to then lead to a decrease in consumption and a lowering of inflation. The biggest problem lies in the solidity of companies that have credit lines in place that are directly influenced by interest rates and this could lead to bankruptcies (as we have seen for some banks in the USA) and to an increase in the unemployment rate .

Only with a deterioration in the labor market will there be room to see a drop in inflation and then review central banks to lower rates again so as to push the economy back to growth. Unfortunately this process will take time.

Original article published on Money.it Italy 2023-04-11 16:00:00. Original title: Perché un’inflazione troppo alta fa male all’economia?