Why inflation is necessary

Rising inflation causes alarm among investors. So far in 2021, the media has been saturated with talk of rising inflation as share markets have gyrated wildly. However, the truth is that inflation is necessary for a healthy economic environment. The RBA tries to maintain an inflation target of 2-3 per cent to keep the economy growing. In this article we discuss what inflation is and why it is necessary.

What is inflation?

Inflation is the general rising of prices. This means that goods and services cost more for the consumer. Hence when inflation occurs the cost of living becomes more expensive and households have less money to spend on non- essential items.

Why is inflation necessary?

Inflation is necessary and because of this, central banks want to avoid deflation. This occurs when the price of goods and services is falling. When this happens, consumers avoid buying products now and plan to buy at another time in the future, thinking that the price will continue to fall. When consumers withhold their purchases until a future date it causes a chain reaction as companies will experience revenue downturn when sales decline. 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. Deflation can lead to recessions and depressions.

A little inflation is optimal for the economy. The inflation target is 2-3% to keep a healthy economy.  When there is a small level of inflation, consumers are encouraged to buy goods and services now because they think the prices will be higher in the future. As demand increases, so does company revenues. This in turn leads to companies expanding their business by, for example, opening more stores and hiring new people. So growth is good for the economy but too much growth too fast will cause the RBA to think about raising rates.  The central banks will look to slow the economy down if they see the inflation being too high as high inflation erodes the purchasing power for consumers. 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. So far there is an expectation of moderate rises in inflation, which means there are no signs yet of dramatic interest rate rises by central banks.

Lauren Hua is a private client adviser at Fairmont Equities.

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