We hadn’t talked about inflation for a long time and now the word is popping up everywhere: it’s front-page news and on everyone’s lips.
Its reappearance coincides with a very particular situation, marked by two years of pandemic upheaval and the shutdown of the economy, as well as by new problems such as the labour shortage, changes in our consumption habits and, above all, global supply chain disruptions.
Added to all these factors was the recent invasion of Ukraine by Russia and its almost immediate impact on key sectors of the world economy.
Will this inflation be temporary or more lasting? That’s the million dollar question. To better understand what’s happening, we offer you a short glossary of inflation and other forms of economic imbalance, as well as the specific situations that characterize them.
What exactly is inflation?
Inflation can be defined as an increase in the price of goods and services available to consumers. Most often, the Consumer Price Index (CPI) is used as a benchmark. This index is based on a basket of goods, created on a specific date, comprising more than 650 everyday consumer items with a base value of $100. The cost of this basket is then reassessed periodically to obtain the percentage change over a 12-month period.
The Bank of Canada has set an inflation target range of between 1% and 3%. When the annual increase in prices remains within this target, the economy is progressing and consumers can maintain their purchasing power thanks to wage increases, or they can adapt their purchasing behaviour without a significant impact on their cost of living.
Central banks essentially use interest rates to control inflation.
- When the policy rate rises, access to credit becomes more costly and consumption slows.
- Conversely, the policy rate is lowered to stimulate economic activity.
Other tools are also available to boost the economy.
Quantitative easing
We have heard a lot about quantitative easing since the financial crisis of 2008. It is in fact a strategy to inject money into the economy. To do this, a central bank buys government bonds on the open market, thereby replacing these savings vehicles with liquidity, which can be used for credit and consumption.
Different economic scenarios
Changes in prices over time can also take other, less well-known forms.
Deflation
When prices decline year over year and the CPI is negative, this is called deflation. Governments and central banks try to avoid this situation because if prices fall, so too do corporate profits. We then see layoffs, resulting in a higher unemployment rate and lower household spending.
To avoid this vicious circle, central banks will use different means to stimulate the economy.
Disinflation
With disinflation, what we have is a slowdown in the rise in prices. In other words, prices are still rising year over year, but at a slower pace. For example, if inflation goes from 5% to 2% in one year, we can speak of a period of disinflation.
Stagflation
Stagflation describes an environment where inflation is high and economic activity is slow or even in recession. Some inflation is quite normal when the economy is running at full capacity, but the situation is more complex when the economy has to be revived.
If a central bank raises its policy rate in order to reduce inflation, this penalizes companies, which will then postpone their investments in infrastructure or in the production of goods and services. It is much more difficult to move the economy forward without stimulating a concomitant increase in productivity. The monetary authorities then find themselves stuck between a rock and a hard place.
The 1970s and early 1980s were a good example of periods of stagflation, which was rampant in the United States, Japan and most European countries.
Hyperinflation
This situation is extremely rare in developed economies. Hyperinflation is defined as an uncontrolled rise in prices of more that 50% per month. This results in a loss of confidence in the entire economic and monetary system of a country. Several South American countries, including Nicaragua, Argentina and Bolivia, found themselves in this situation in the 1980s and 1990s. Today, Venezuela is in the grip of endemic hyperinflation.
In conclusion
All of these scenarios describe situations of imbalance between supply and demand, the effect of which is felt first and foremost by consumers of goods and services. The situation we find ourselves in in 2022 continues to evolve and we will see over time whether the actions taken by central banks will have the hoped-for stabilizing effect.
