What does inflation mean?
Inflation is the increase in the general level of prices for goods and services over a period of time. When inflation goes up, this means that the amount of money you have to spend on goods and services will be worth less and vice versa.
What causes inflation?
A number of factors can cause inflation, including changes in supply and demand, changes in consumer confidence, expectations about future price increases or decreases, government policies designed to influence prices (such as setting quotas on imports or tariffs on other countries), or more abstract factors like natural disasters or wars like the invasion of Ukraine by the Russians.
Why is inflation so high?
There a number of reasons why inflation has been so high. Here are some of them:
The Ukraine War - The consequences of the Russia-Ukraine war are immense and range from soaring food prices to social unrest. Russia is a huge supplier of oil, gas, and metals. Ukraine on the other hand is a big supplier of corn and wheat. The law of supply and demand tells us that when there’s a conflict in a major producing region, prices go up. And as such, the prices of these five commodities, among others, have gone up sharply all over the world due to reduced supplies.
Demand Outstripping Supplies - Consumer demand has been growing faster than the rate of production once people got their corona virus vaccine, leading to shortages and consumer inflation. Global supply chains continue having issues that are a contributing factor to the sky-high prices we’re continuing to see everywhere.
Jobs Market - Even with a strong job market especially after people got their coronavirus vaccines, the world is seeing historic levels of both job openings and people quitting. This is forcing companies to pay higher hourly earnings to keep workers, causing employers to pass the extra costs onto consumers.
Trillions in Stimulus Money - During the COVID-19 pandemic, governments from all over the world flooded trillions of dollars into the system to keep the global economy moving. When the government prints more money, it devalues the currency, decreases consumer purchasing power, and leads to our current financial situation. One way or the other, these governments make that money back for example via increasing taxes.
How does raising interest rates affect inflation?
When the Federal Reserve responds to high inflation by raising interest rates, it effectively increases the level of risk-free reserves in the financial system, limiting the money supply available for purchases of riskier assets. Conversely, when a central bank reduces its target interest rate it effectively increases the money supply available to purchase risk assets.
By increasing borrowing costs, rising interest rates discourage consumers and businesses from spending, especially on commonly financed big-ticket items like housing and capital equipment. Rising interest rates also tend to weigh on asset prices making banks more cautious in lending decisions.
When will inflation go down?
It still may take a couple of years, but as we see supply chains finish adapting to these new realities and find a better balance supply with demand, we might start to see prices come down. Most experts expect that prices will stay high for the rest of 2022 but will eventually fall in the next two to three years.
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