Inflation: How Does the Rise in Prices Affect You?
27 de July de 2022
27 de July de 2022
In the streets, on the news, on the press… The word “inflation” has found its place in our everyday life, yet not many of us know what it really means. Until recently, it was a term that barely left economic environments and didn’t feel like a threat in Europe. During the past months, though, we’ve all become familiar with its effects.
From late 2021, inflation has been steadily growing in the main economies of the world. The Eurozone is already at 8.6%, similar to the United States. In Spain, it’s above 10%. But, what does it entail to have high inflation? How does it affect companies and the domestic economy? How can it be addressed?
Inflation is an economic process caused by an existing imbalance between supply and demand, resulting in a continuous rise in the prices of most products and services and a fall in the value of the money needed to acquire or make use of them. The imbalance between what’s produced and the amount of money in the market is the cause of inflation.
Inflation, on itself, is not bad. Experts say that it’s healthy for the economy to have an inflation under 2% since it benefits the economic cycle. Now, when it rises above this number, money starts losing value. The same problem arises when the opposite happens (deflation) and there’s a continuous fall in prices.
Many factors have triggered the current situation. Injecting capital in the market during the pandemic has given place to problems in the production and logistics of supplies ever since then. There has been an imbalance between the production and the amount of money in the market and, now, we end up paying for more than we get. This has been further complicated by the subsequent energetic and supply crisis that followed the Russian invasion of Ukraine.
a) Reserve Requirement:
Banks are required to keep a certain amount on their deposits in order to control the amount of money that’s being created, thus guaranteeing its solvency in the short term. This forces entities to reduce the money they can lend and sets limits to mortgages. Through reserve requirements, regulators can control the amount of money that circulates in the market. For example, a reserve requirement of 1%, requires banks to keep a legal reserve of 1 euro and allows them to invest 99.
b) Open Market Operations:
Buying and selling debt securities offered by central banks. One of the first measures carried out by the European Central Bank (ECB) when inflation started rising was to propose a reduction of the debt programme that had skyrocketed with the pandemic due to liquidity problems. In hindsight, this situation of excess money in the market exploded when world productivity was affected, which forced regulators to change their monetary strategy.
c) Types of Interests:
The most famous one could be defined as the money we must pay for taking a loan. If the type of interest rises, we need more resources. Banks apply the type of interest to companies and citizens, but also central banks apply it to banks who turn to them for financing.
After decades with no rise in the type of interest, recently, both the Federal Reserve System of the USA and the ECB have carried out a momentous rise. This makes money more expensive and gives place to an increase in loans. Although the most immediate effect is a stalemate in investment and consumption, regulators hope to stop the rampant inflation.
Inflation has a direct effect on the sales prices, which means that if we can raise the prices at the same rate as costs rise, we will keep it in balance. But it’s not always possible to raise the prices on our clients and it will depend on how easy it will be for them to find cheaper alternatives. In this case, it will become more difficult to keep up our profit.
In the current situation, all production costs have risen. Suppliers and inventory tend to rise. What used to cost 1€, now costs 2€. Investing, growing and taking debt all becomes harder. This has an effect on the creation of new business projects and on the development of value in companies. Eventually, the whole economy feels the effects of inflation and comes to a stalemate.
A home isn’t that different from a company. Families are natural savers and potential investors as well.
Nevertheless, given the current situation, the best advice would be to try and increase those savings, especially for those who have mortgages, since they can have higher risks.
If there’s not a corresponding rise in salaries, the rise in prices will have an effect on our purchase power. Currently, everything costs more: food, transportation, restoration, electricity, etc.
Housing, which is the great patrimonial refuge of families, is experiencing a big fall due to the rise in types of interest. The same is true for bonds and shares. In the long term, capital loses value and families lose purchasing power, especially if they don’t have the capacity to endure through the situation without having to sell. With a structured and diversified economy, overcoming inflation will always be easier.
Inflation brings along the loss of purchasing power and slows down the economy. Central banks work on adjustment measures that will lower the price of money.
Article written in collaboration with Javier Fernández-Pacheco, Family Banker at Banco Mediolanum and Finance professor at EAE.