What Causes Inflation? | Family Finance


Hyperinflation can be extremely harmful to consumers, but deflation is also considered undesirable by economists. The causes of inflation – and how severely the factors that trigger inflation affect consumers – vary and have undergone much debate among economists historically.

The existence of inflation itself, however, is expected.

“Inflation is normal,” says Brian O’Leary, wealth advisor and senior analyst at ALINE Wealth. “We don’t have to fear the fact that inflation exists, and in fact, it is healthy in the economy. The issue becomes what amount of inflation is appropriate.”

What Causes Inflation?

Inflation is caused by factors like pressures on the supply or demand side of the economy, money supply policies and even consumer expectations.

Economists define inflation as the rate of increase in prices over a given period of time. It is typically a general measure referring to the overall increase in prices or cost of living in a country. Its causes can vary, but rising prices in one particular sector doesn’t necessarily point to broad inflation.

“The price of any particular good going up or down is not inflation,” says Michael Rosen, chief investment officer at Angeles Investment Advisors. “Inflation is caused by the supply-demand imbalance of money, not the supply and demand imbalance of a particular good, like the cost of an airplane ticket or the price at the pump.”

Today’s high rate of inflation was caused, in part, by factors related to the coronavirus pandemic. The consumer price index rose just 2.3% from 2018 to 2019 – near the Federal Reserve’s target inflation rate of 2%. But as the economy began to recover from the effects of the pandemic and following various governmental efforts to stimulate the economy during the pandemic, the annual CPI hit 8.5% in March.

“We had a period of a year and a half where people were mostly locked in their houses and saving more than normal,” says Gary Zimmerman, managing partner of Six Trees Capital in New York and founder of MaxMyInterest.com. “Now they want to get out and spend, and they’re willing to spend more. Until that novelty wears off or until prices rise to the level where it starts to really impact demand or consumption, we’ll continue to see pretty high levels of inflation.”

Types of Inflation

Periods of inflation can come about unexpectedly as the result of global events, like the pandemic or the Russian invasion of Ukraine. But there are generally three types of inflation:

  • Demand-pull inflation.
  • Cost-push inflation.
  • Built-in inflation.

Demand-pull inflation is characterized by excess demand in the market that supply cannot meet alongside a low or falling unemployment rate. This type of inflation is often caused by rising wages, rising house prices and low interest rates.

Cost-push inflation is characterized by higher commodity prices and is often caused by high production prices or high costs associated with raw materials.

The third common type of inflation is connected to consumer expectations.

“People have started to acknowledge that inflation is more than transitory, and that, in and of itself, is important because inflation can be self-perpetuating,” Zimmerman says. “If there’s a view that inflation is temporary, then suppliers and retailers will be reluctant to increase their prices, but once the narrative has evolved to, ‘inflation is here to stay,’ it gives companies and their supplies cover to start raising pricing. ”

How Governments Respond to Inflation

Central banks are often tasked with maintaining price stability. The Federal Reserve, for example, has so far responded to today’s high inflation rates by raising interest rates 0.25% in March in an effort to cool off an overheating economy.

Governments have a number of levers to pull when attempting to control inflation. Contractionary policies, which aim to reduce the rate of inflation, include raising interest rates, fixing the exchange rate by tying the value of one currency to another and price-setting measures.

One of the most widely cited historical examples of governments attempting and – in many ways failing – to control inflation is the period in the 1970s and 1980s, known as the Great Inflation. During this period, inflation hit as high as 13.5% year over year.

There was significant debate at that time, Rosen says, around the causes of inflation and how to best respond that mimics the conversations being had about inflation today.

“There was a lack of the fundamental understanding that supply and demand is what’s really behind inflation, and you see the same kind of discussion today,” Rosen says. “It’s hard to fully articulate with the data just how awful the economic conditions were in the 1970s and 1980s for almost everyone. We’re not even close to those conditions today … But what is similar is a Federal Reserve that has been slow to tighten policy and tighten money supply in the face of rising demand.”