Inflation hits 40-year high! So what does inflation mean?
Inflation has been reported in the news recently. Coupled with the outbreak of the Russian-Ukrainian war, global inflation has been out of control. It has even reached a new high in nearly 40 years. Even US President Biden warned that US inflation “may be continued for a period of time”. So, do you understand inflation well enough? And what causes inflation? Let’s view more!
What is Inflation?
Inflation refers to “the general price level continues to rise at a considerable rate within a certain period” or “the purchasing power of the equivalent currency continues to decline”. Simply put, it is the continued rise in general prices. But inflation is a composite data, and does not reflect the rise of every commodity.
The consumer price index (CPI) is usually used to measure inflation, and central banks use the core consumer price index (Core CPI), which excludes short-term volatility such as vegetable, fruit and energy prices, as a reference.
The causes of inflation
People’s purchasing power becomes lower, either because too much money is printed, which reduces the value of the currency (the traditional definition of inflation), or because all the necessities of life become relatively expensive (aka rising prices). The causes of inflation are: increase in demand, rising costs, salary issues, insufficient supply, the description is as follow:
Increase In Demand
When the supply of money and credit increases, stimulating the overall demand for goods and services in the economy is too large, inflation with a demand-pull effect will occur.
When an increase in the supply of money or credit is pushed into the commodity or other asset market, it increases the cost of various intermediate goods. As a results, it will lead to higher costs of finished goods or services, and also raise consumer prices. Especially when it is accompanied by a negative economic shock to the supply of key commodities.
Workers’ desire to keep raising wages has also led to higher prices for goods and services. This is the result of a combination of internal factors, that is, rising product prices make employees need higher salaries, and higher salaries in turn raise product prices.
Because epidemic has disrupted the global supply chain of some goods, such as the shortage of wafers, the production of automobiles has been limited. When the commodity is in short supply, the price of the commodity will rise.
Types of inflation
After we understand the causes of inflation, we can divide it into 4 main types of inflation according to the speed of inflation in each year:
Creeping Inflation：Annual inflation rate <= 3%
An inflation rate of 3% or less can be called creeping inflation, and being in such an inflationary situation will make consumers expect prices to continue to rise. As a result, consumers will boost demand in order to pre-purchase lower-priced products. In other words, creeping inflation will be a way to promote economic expansion. We generally regard this kind of inflation as the normal state without high inflation.
Therefore, the US Federal Reserve (FED) has set 2% as the target inflation rate.
Walking Inflation：Annual inflation rate 3%~10%
When the inflation rate reaches the walking inflation rate of 3~10%, it will start to have a negative effect on the economy. Because people will buy more products than they really “need” to avoid higher prices. At this time, the rapid increase in purchasing behavior will further drive the demand for products, which will make suppliers unable to keep up, and consumers’ wages will not be able to cope with consumption.
As a result of waking inflation, the prices of common products and services begin to exceed the range that most people can afford. Generally speaking, the central bank will try to raise interest rates, to avoid further deterioration of inflation.
Galloping Inflation：Annual inflation rate > 10%
Galloping Inflation means that the inflation rate rises to 10% or higher. It represents the beginning of an absolute recession in the economy. At this time, the rate of depreciation of money is quite fast, the income of enterprises and people simply cannot keep up with the price of products. In the case of regional inflation in a single country, foreign investors will also start moving money out of the country due to currency devaluation.
Various phenomena caused by rapid inflation can make the economy quite unstable. The government usually has to make countermeasures to prevent it.
Hyperinflation：Annual inflation rate > 50%
There is no generally accepted standard for hyperinflation. It is generally considered to be an out-of-control situation in which prices rise by more than 50% each month or hundreds or thousands of times in a year.
At this time, prices have skyrocketed, and the currency has fundamentally lost its original value. At this time, people will lose confidence in the local currency (fiat currency, or fiat currency). When it’s happened, the currency will drop at a very fast rate, and prices will increase by more than 50%.
How is inflation measured?
Inflation is reflected in rising commodity prices, so it is usually observed through the Price Index (CPI & PPI) and Wholesale Price Index.
Consumer Price Index (CPI)
The Consumer Price Index (CPI) measures the price of goods and services from the standpoint of consumers. Generally speaking, if the CPI index continues to rise, it means that inflation is showing signs of rising. Under the same income level, the purchasing power of the people will decline with the rise in prices, and the impact is quite extensive. Changes in the CPI are used to measure changes in prices relative to the cost of living. That’s why it is one of the most commonly used statistics to identify periods of inflation or deflation.
Wholesale Price Index (WPI)
Wholesale price index is an indicator used to measure the price situation of purchasing goods faced by producers. Compared with CPI, another index that measures prices, WPI includes three stages of information on manufacturers’ raw materials, semi-finished products and finished products. The cost of these production levels may affect future changes in inflation. Therefore, WPI and CPI are long-term. The correlation degree is very high, and it is also an important inflation observation indicator.
Therefore, the correlation between WPI and CPI is very high in the long-term, they are both important indicators of inflation.
The WPI measures the purchase price. It is highly correlated with the CPI, but the short-term data of the two may be very different. The reason is that the WPI measurement factor only includes goods but does not include labor services. While the CPI includes the final commodity and labor included.
Producer Price Index (PPI)
The Producer Price Index (PPI) is used to measure the price status of the goods that producers need to purchase in the production process. Therefore, the index includes price information for three production stages, including raw materials, semi-finished products and final products. In theory, the price fluctuations faced in the production process will be reflected in the price of the final product. Hence, observing the changes in PPI will help predict future price changes, so this indicator is valued by the market.
The difference between CPI & PPI
The PPI and the Consumer Price Index (CPI) are both well-known inflation measures. In the long-term, the two are highly correlated. But from the short-term data, the CPI and PPI may be very different. This is because the CPI counts the prices of daily necessities for general consumers, and the statistical scope includes goods and services. While the PPI only includes goods, and the constituent items include capital equipment that is not included in the CPI.
In practical applications, since PPI data is released earlier than CPI, analysts usually use the price fluctuations of final products in PPI to predict the upcoming CPI report. While the price statistics of raw materials and semi-finished products in PPI can also be used to predict future inflation.
When the price index increases by 3%, it means that the purchasing power of the currency decreases by 3%, compared with the same period in the past. Each commodity is affected by inflation to a different extent. The price information published by the government will also list the price rises of different commodities by category, including food, rent, clothing, medical care, etc.
**Note: The inflation index is just an “average”.
The inflation index is a composite data. Because the inflation index only reflects the overall average, maybe the inflation index shows 2%. But if the consumer goods or real estate that are related to our lives rose 5% to 10%, which still has a huge impact.
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