What is Inflation?

What Is Inflation?

Unhelpfully, dictionaries define inflation as the condition of being inflated! Consumers know it better as a general increase in prices and a fall in the purchasing power of money.

Inflation is when you pay €15 for a €10 haircut that cost €5 when you had hair!!

The Central Statistics Office has the unenviable task of compiling the Consumer Price Index – the official measure of Irish inflation, which quantifies the change in the average level of prices paid for consumer goods/services by all private households/foreign tourists.

Ireland’s annual inflation rate was 0.7% in 2018 – meaning the average level of prices rose by that much in the full year. But how accurate is that? Many consumers who pay rent and smoke cigarettes and drink wine saw their costs rise by 10% plus. While those who own their own home, smoke CBD extracts and drink water remained unaffected by inflation. In this context the word “average” is very real and produces highly misleading consumer outcomes.

Many cynics believe that the inflation figures are deliberately manipulated to dilute wage claims and social welfare pay-outs. Those less cynical still see worrying aberrations in the calculations that are not reflected in the price increases witnessed on the ground.

In the US, the Chapwood Index is a hugely popular measure because it is designed to reflect the absolute true cost-of-living increases – broken down by region/sector it is less reliant on general averages. This US index consistently highlights that incomes do not cover current expenditure and that most households run up debt. This is completely at odds with the standard calculation of inflation averages. Unfortunately, Ireland does not have a similar index.

There are two primary types of inflation. Cost-push inflation where there is an unexpected dislocation in the supply of goods; thereby, pushing up prices. Demand-pull inflation where there is a surge in demand for goods (usually accompanied by low unemployment levels). Neither can be anticipated with any certainty, although, economists do have signals that help predict likely inflation levels. For example, natural disasters might restrict the supply of an important commodity or affluent economic conditions might influence consumers to spend more. Both are good indicators of potentially higher inflation.

A little inflation is a very positive driver of economic activity. If house-buyers envisage prices rising they are likely to purchase now rather than wait. And if home-owners see property prices rising they feel more smug about buying a new car or spending more on a holiday. Rampant inflation is not welcome because prices rise too much and too quickly for consumers to adjust. And, similarly, very low inflation risks the possibility of prices falling – consumers putting off purchases and home-owners becoming very worried.

The sweet spot has traditionally been seen as an annual inflation rate of 2% – and many Central Banks have this target stitched into their strategic objectives. But that tradition arose when interest rates were much higher. A persistently low interest-rate environment is a fresh challenge to definitions of inflation.