Inflation is often portrayed as a problem for the economy and the share market. With interest rates at record lows, and central banks printing money like never before, investors are concerned about inflation heading higher. However, a low level of inflation is healthy for the economy. In this article we discuss what the causes of inflation are and how it is good or bad for the economy.
What does inflation mean?
The simple definition of inflation is the general rising of prices. This means a decrease of purchasing value for goods and services. For the average consumer it means there is less money in the household budget when inflation rises. This in turn leads to less funds for discretionary spending.
Causes of inflation
There are various reasons for inflation. One of the causes of inflation is when the economy heats up too fast and demand exceeds supply. This can occur when there are labour shortages and employees can demand higher wages which can give them more money to spend of goods and services. Another reason for inflation is when companies face increased costs associated with their goods and services. This is because they can usually pass these increased costs back to the customer. For example, if oil prices have increased, then companies which use oil to manufacture their products will increase the prices to the consumer so their margins don’t go down.
When is inflation good?
The RBA sets out an inflation rate of 2-3 per cent so a moderate level of inflation is good for the economy. The opposite of inflation is deflation which is also bad for the economy. Deflation is the decrease of the general price of level of goods and services. Why would deflation be bad as it means the prices of goods and services are cheaper for the consumer? There are negative consequences for deflation as is may encourage consumers to save money and not spend if they think their potential purchase will be cheaper in the future. This causes a domino effect as a company’s revenue can decrease when consumers hold out buying now to buy in the future for a cheaper price. Redundancies and wage reduction can follow when companies see falling revenues. A rise in unemployment can exasperate the situation as household spending will be further tightened.
When is inflation bad?
When inflation is higher than the set level by the RBA of 2-3 per cent, it is considered too high. High inflation erodes the purchase power of consumers as the prices for goods and services are higher. When inflation is too high, household budgets are stretched as the general level of prices have become more expensive so consumers have less capacity to spend money on discretionary items. Similarly, to deflation, when consumers decide to reduce spending on goods and services, it can cause a chain reaction of redundancies and high unemployment which further impedes economic growth. High inflation also negatively affects savers as it can reduce the value of money. If savers are getting an interest rate which is lower than the inflation rate, then they are worse off. High inflation also affects the interest rates as central banks will raise rates if they see it suitable to slow the inflation rate. If they think economy growth is growing too fast, higher interest rates will slow down businesses from borrowing money to invest in their businesses. High interest rates are a negative for the stock market as debt obligations would increase when the interest rates are hiked which can slow the company’s growth. We have previously written on the effects of interest rates and the stock market on the following link The Effect of Interest Rates on the Stock Market.
Lauren Hua is a private client adviser at Fairmont Equities.
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