Inflation: What Is It and Why Is It Currently High?

The one word on everyone's lips at the moment is inflation. Reported inflation is at a level that has not been experienced for decades – nearing double-digit, a number that would have been inconceivable only just a few years ago. The ability of governments and central banks to "sit and wait" is waning, and they must take action to avoid severe economic decline.

Let's begin with the definition of inflation, as defined by the Bank of England.

Inflation is a measure of how much the prices of goods (such as food or televisions) and services (such as haircuts or train tickets) have gone up over time.

Usually people measure inflation by comparing the cost of things today with how much they cost a year ago. The average increase in prices is known as the inflation rate.

So if inflation is 3%, it means prices are 3% higher (on average) than they were a year ago. For example, if a loaf of bread cost £1 a year ago and now it’s £1.03 then its price has risen by 3%.

– The Bank of England

Most economists agree that a slow and steady increase in price (i.e. inflation) is a good thing for a healthy economy. Central banks in developed economies such as the Bank of England (UK) "BOE", the Federal Reserve (US) "The Fed" or the European Central Bank (EU) "ECB" have an inflation target of 2%.

Central bankers control inflation by implementing a range of policies to adjust the money supply (the total amount of money in the economy at a particular point in time). The most effective methods are through changing the interest rates, or quantitative easing or tightening (central banks purchasing or selling government bonds to increase or decrease the money supply).

Inflation only becomes worrisome when it's persistently high, and central banks have lost their ability to maintain inflation at, or around their 2% target.

Why Are Economies Experiencing High Levels of Inflation?

At the beginning of the Covid-19 pandemic, the US, UK and other advanced economies decided the best way to mitigate any potential adverse impact from the Covid-19 pandemic is a form of expansionary monetary policy – i.e. central banks expanding the money supply faster than usual, by using methods such as lowering interest rates or increasing use of quantitative easing. Consequently, the money supply increased at a record pace, to levels exceeding those during the great recession – this is what has caused inflation.

We've experienced historically low central bank interest rates since the financial crisis in '08/'09. Low-interest rates mean is cheaper for economic participants to borrow, so consumers borrow more. A lower interest rate is also a disincentive to saving – what's the point of saving if you earn next to nothing in interest on your savings?

Since consumers have more cash available (as a result of their borrowing), and less cash is being saved (low to zero interest rates), and central banks have implemented quantitative easing, there's more cash circulating the economy. If the rate of the increase in cash exceeds the rate of the ability of service providers and manufacturers to supply or produce goods or services, the economy experiences inflation. Prices rise as there's more cash chasing fewer goods and services.

Following the financial crisis, since most economies were in a recession, the low-interest rate environment did not result in high levels of inflation. Instead, the system worked as designed to stimulate demand, resulting in moderate growth and alleviating the effects of the recession.

However, at the height of the Covid-19 pandemic, governments and central banks across the globe were perhaps too eager to print trillions of dollars, without understanding the impact that the Covid-19 pandemic could have on the economy. They feared a sustained recessionary period. However, it turned out that the markets would experience a quick rebound.

As trillions of dollars were created over such a short period, and interest rates were at an all time low, can we really be surprised about inflation? I kept telling everyone willing to listen that we were going to experience high levels of inflation. If only I were running a hedge fund with billions of dollars to bet on my conviction...

Given the increase in the money supply over a short period, it's no surprise that we're currently experiencing high levels of inflation.

Monetary policy (such as expanding the money supply) usually has a lag of about 12 to 24 months for its full effects to be felt within the economy. That's exactly what we've experienced – the policies that governments and central banks implemented at the start of the pandemic are starting to make their way through the financial system, and we shouldn't be surprised that inflation is running wild.

United States Money Supply

To understand how much cash was created and injected into the financial system in 2020 and 2021, let's take a look at the US money supply. In its simplest terms, the money supply is the total amount of money in a country's economy at a particular point in time; it includes liquid assets such as cash, current accounts, savings deposits, and liquid money market assets.

During the period between April 2020 and December 2021, the US money supply increased by 47% from c.15tn to c.22tn. A simple way to think about this is that almost half of all dollars in existence were created during these 20 months.

The Fed and many other central banks in the west made a decision they felt was appropriate at the time, given the circumstances. Inflation is a side effect of increasing the money supply exponentially within a short space of time.

Half of all dollars in existence were created during a 20 month period.

Governor of the Bank of England "Don't Ask for a Big Pay Rise"

Inflation impacts every economic participant within an economy in one shape or form; these participants include high/low earners, unemployed, small and medium-sized businesses, large corporations, central and local governments, schools, hospitals, churches – everyone and every organisation!

In absolute terms, the greatest impact of an increase in interest rates would be felt by corporations, the largest of which could see the amount of interest they pay each year rising by several hundred million pounds. However, they also have the financial means to pay for advisers such as myself, who could help them to restructure their debts, or pass on a proportion of their increased costs to consumers. Those who would suffer the most are everyday people, who are already struggling to make ends meet.

As inflation impacts economic participants disproportionately, those most likely to feel the adverse effects of high levels of inflation are:

1. Those who are not able to pass on the increasing cost to others;
2. Those with limited financial capital who are unable to restructure their finances; and
3. Low earners who are unable to increase their incomes by a meaningful amount.

Low earners were already feeling the pinch before the effects of inflation started to work their way through the economy; these low earners will experience the sharpest increase in their cost of living, resulting in the lowest earners struggling even more to make ends meet.

So when Andrew Bailey, Governor of the Bank of England tells people not to ask for a pay rise, it comes across as insensitive and out of touch. Here's an objectively successful man who's in his 60s, at the peak of his career, presumably a millionnaire, telling ordinary citizens not to ask for a pay rise, even though their cost of living has risen by 7% in the year alone.

The only solution to the problem appears to be for workers, particularly low earners, to ask for, and receive a pay rise – going against the comment by Andrew Bailey.

So why did the governor of the Bank of England tell people not to ask for a pay rise?

To control inflation, the Bank of England decided to double the central bank rate from 0.25% to 0.5% – the rate has risen 5x in the space of a couple of months, rising from 0.1% to its current level of 0.5%.

Economic theory tells us that increasing interest rates impacts borrowers, such as; businesses (it raises the costs of servicing their debts); homeowners with a mortgage (who would see their mortgage payments rise by thousands of pounds each year); and consumers with debts (credit cards, overdrafts, store credit, etc). Since borrowing becomes relatively more expensive, businesses can't afford to pay people more, and it becomes more expensive for people to borrow money to fund their lifestyle or consumption of goods and services – resulting in less disposable income for workers.

Raising the central bank rate also encourages people to save more as savers, in theory, should earn more interest on their savings. As people save more, spending reduces in relative terms. The effect is that there's less cash circulating the economy, and coupled with reduced demand for goods and services, prices rise more slowly, therefore lowering the rate of inflation.

I am in no way trying to justify Bailey's comment – I maintain that it was insensitive and out of touch. However, there is an economic rationale for the Governor of the Bank of England's comments.

To control inflation, the Bank of England need businesses and consumers to have less disposable income, so that they spend less, reducing demand for goods and services – therefore prices rise slowly.

If the country, in aggregate, gets a big pay rise, it would make his attempt to control inflation through contractionary economic policy ineffective.

If workers receive a big pay rise, despite the increase in the central bank rate, workers will have greater disposable income, which would enable them to purchase more goods and services (i.e. stimulating the demand for these goods and services), without having to borrow to fund this consumption. Assuming the supply remains constant, prices will rise, leading to inflation – this means that the opposite effect of the Bank of England's economic goal will be achieved.

Despite the economic justification of Bailey's comments, when millions of people are already feeling the squeeze, and the country is experiencing the biggest fall in living standards since records began in 1990, telling people not to ask for a pay rise makes Bailey appear out of touch with reality and unaware of his privilege.

Doing his job as the Governor of the Bank of England, and implementing policies that would help the country, without disproportionately harming the most vulnerable in our society over the short, medium, and long term is a wiser approach.

Don’t ask for a big pay rise, warns Bank of England boss

Andrew Bailey says a “painful” period of prices rising faster than wages is needed to control inflation.

BBC NewsSzu Ping Chan

Subscribe below to receive new post updates the minute they are published. You will also receive my newsletter, where I share interesting and insightful articles, books, quotes and lessons that I have learned.