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Category: Glint's Helpful HInts

Glint’s Helpful Hints: Inflation and deflation

Inflation is back in the news on both sides of the Atlantic. In the US in 1974, President Gerald Ford called inflation 'Public Enemy No. 1'. But what...

16 June 2021

Gary Mead

Inflation is back in the news on both sides of the Atlantic. In the US in 1974, President Gerald Ford called inflation ‘Public Enemy No. 1′. But what actually is it? And what is its opposite, deflation?

The International Monetary Fund (IMF) defines inflation as being how much more expensive goods (e.g. a car or a house) and services (the plumber or electrician for example) become over a certain period, usually one year. Measuring inflation – how much prices have gone up – can of course be done in various ways and over various time-periods.

Governments tend to measure inflation month-by-month, using a basket of goods and services, and then extrapolate that to an annualised rate. What that basket contains – the Consumer Price Index (CPI) in the US – is tweaked from time to time, to try to reflect changes in consumer spending.

So for example, UK inflation as measured by the Office for National Statistics rose 2.1% this year in May, up from 1.5% in April and the highest level since July 2019. The figure for the US CPI in May was 5% year-on-year, the fastest rise in almost 13 years. Prices in general are thus this year running about 2.1% higher in the UK and 5% higher in the US than last year.

Even small rates of annualised inflation can have a large impact on consumers’ purchasing power. For example if inflation is running at 0.25% month-on-month, about 3% on an annualised basis, that compounds to a 14% loss in purchasing power – what your fiat currency can buy you – over five years.

Some companies – particularly in the fast-moving consumer goods (FMCG) sector respond to price inflation by making smaller packages of a product yet charge the old price: this is called ‘shrinkflation’. That way they can surreptitiously cut their costs while hoping consumers don’t notice they are getting less for the same money.

Deflation is a decrease in the general price level of goods and services over time. This means that you could tomorrow (or next month or year) buy more of the same with the same amount of money. A consumer might think that deflation is a good thing – what better than falling prices?

Bu that’s not how central bankers, policymakers and governments think. They agonise over trying to get just a little inflation – the US and the UK both ‘target’ inflation to be around 2% a year – in the system, and trying to keep deflation out. The reason they loathe deflation is because falling prices means that consumers put off spending, in the hope that prices will fall even further. Companies respond to falling prices by slowing production, leading to unemployment, lower wages, greater demands for state income support, and so on.

So governments are happy to sacrifice your purchasing power – which gets reduced over time thanks to inflation – in order to keep the wider economy stable. They want inflation – just a little bit – and don’t want deflation.

Yet inflation really is a good candidate for Public Enemy No. 1. Inflation steadily, stealthily, reduces your wealth. What you could buy for $1 in 1971, 50 years ago, would require $6.56 today; that 1971 Dollar today buys you just 15.04% of what you got 50 years ago. A similar story holds true for the UK; inflation averaging 5.6% a year since 1971 means you would need £14.46 today what you could have got for £1 fifty years ago.

Inflation is caused by many things and impacts on many sectors of an economy. The question for policymakers today is – is the current inflation spike controllable?

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