Inflation and why it matters

Inflation in many countries, including Australia, is at  multi-decade highs. But what is inflation, and why does it matter?

Put simply, inflation is an increase in the price of the goods and services households buy. You may be wondering what causes inflation and how it affects the economy and you. Below we look at the root causes of inflation through the lens of supply and demand drivers of prices.

Supply-side inflation

Supply-side inflation may occur when companies are constrained in supplying goods and services by economic or geopolitical conditions, or uncontrollable factors such as the weather. This can result in ‘cost-push’ inflation, where higher costs of production are passed onto consumers as higher prices.

Supply chain bottlenecks

In a global economy, the production of goods often involves many different companies, countries, and transport delivery systems working together effectively. Together, this is called the supply chain. When a supply chain gets bottlenecked, it can lead to cost-push inflation. COVID lockdowns saw many businesses ordered to shut, people having to stay at home, forcing factories to close and curtailing services.

Supply side case study – mobile phones, microchips and cars

A mobile phone casing may be manufactured in China, the microchip that runs the phone in Taiwan, and the glass face and assembly might be finished in the US. If any one of these global processes is held up, it stops the creation of the final product, ‘the phone’, causing  a supply chain disruption, resulting in a shortage of this product. This pushes up prices.

Microchips are a good recent example.. Their production is concentrated in just a few places globally, such as Taiwan and South Korea. The pandemic lockdowns in these countries severely curtailed their production. And even though microchips represent a very small part of, say, a car, without them the car cannot be completed. This has recently caused a global shortage of new cars, increasing  their price and the prices of  secondhand cars, as we shown in Figure 1 below. Supply chains are often complex and any issues can take some time to resolve.

Figure 1 – Shortages and bottlenecks hit rebound in automotive sector

Slowing investment in certain industries

Underinvestment in an industry can also cause inflation. For example, if there has been a lack of investment in developing new mines for a resource or commodity, supply can be constrained in the short to medium term. Because new supply is limited, buyers have to source their needs from a reduced, or insufficient pool of the resource. This means buyers have to compete to buy the resource, pushing up the price. Investment in the production of commodities tends to ebb and flow and is sometimes known as the commodity supercycle.

Geopolitical drivers

Geopolitical conditions can also have an effect on supply-side inflation through political decisions, such as sanctions, physical constraints, or a combination of both. The war in Ukraine illustrates this. Ukraine and Russia are two of the largest producers of wheat, and Russia is one of the largest exporters of energy. In addition to the terrible human cost, the war has meant that the Ukraine has only been able to produce a fraction of its normal output. Sanctions against Russia have also curtailed its ability to export oil and gas. These conditions have contributed to a shortage in wheat, oil, and gas with the result that prices have spiked.

Weather

Extreme weather conditions, like flooding or drought can also significantly impact growing conditions and yields, pushing up food prices. This has been evident recently in Australia as flooding in New South Wales and Queensland has disrupted supply and led to higher prices for fruit and vegetables.

Demand-side inflation

Demand side inflation is caused when companies and households want more of a particular good or service for which supply is constrained. This is sometimes called ‘demand-pull’ inflation, where there is simply too much demand for a good or service than can be supplied, driving up the price.

The increase in demand can be caused by improving economic conditions, such as growth in an economy and employment, which means people have more money to buy things. It can also be caused by government actions to help the economy or society, for example by stimulating the economy by creating more money (sometimes known as quantitative easing) or sending money to people under extreme conditions. A recent example of this locally is the Covid stimulus packages, including early access to super and JobKeeper during the pandemic.

Both of these government actions may have contributed to an increase in prices, as there is more money (demand) chasing a limited supply of goods.

Pulling it all together

Inflation can be complex with lots of potential and intertwined causes and effects. Inflation can also take time to tame and can have a significant impact on economies and societies. It’s why many central banks (the independent bodies within countries responsible for controlling interest rates), including the Reserve Bank of Australia, are so focused on moderating inflation and are now quickly raising interest rates to try and keep it under some control.

Important information:

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