What is inflation and how does it work?

What’s inflation?

Inflation is the lessening of a currency’s purchasing power in an economy and, as a result, it’s also synonymous with rising costs of living. When inflation rises, the same amount of money is worth less than it used to be.

As a result, buying the same things costs more, because the value of the money itself has dropped, so it takes more money to buy the same items.

Because inflation makes money worth less, it’s problematic for any non-inflation linked investment as it lowers the real value (ie the purchasing power) of those returns.

Find out how you can trade on inflation

Causes of inflation

Inflation is usually measured within a country, and the causes of it domestically are the same as most economics: supply and demand. However, inflation rarely happens within a single country in isolation. Instead, there are a wide variety of global economic factors at play.

Often, a major world economy (for example the US) will increase inflation for macroeconomic reasons, which will then have a domino effect on the majority of other currencies in the world, causing inflation in those countries, too.

There are several factors that might lead to this:

1. Demand-pull inflation
2. Cost-push inflation
3. Devaluation
4. Undersupply due to lack
5. Oversupply of money itself
6. Built-in inflation

Demand-pull inflation

When there’s rapid economic growth, there’s a greater demand for money in all regions. Infrastructure spend is up, wages for workers increase, consumers buy more goods and so on. It can lead to the demand for money outgrowing the supply of that currency, which often means that country will need to print more money.

Surely this should mean the money is worth less because there’s more supply? Not usually. This is because the amount of items that economic growth demands – eg more goods for shoppers, more materials for infrastructure construction – are likely still the same. This causes the price of those things to increase as well, as the demand’s increased. So, the money can still purchase less than it did before.

This same logic can also apply to any export, import or service that a country’s economy is highly dependent upon – if there’s suddenly more demand than there is supply. For example, if a country is dependent on grain produced by another country, but a drought causes a scarcity, this could lead to inflation in both countries as that commodity is more expensive.

Cost-push inflation

Rather than scarcity pulling costs up, production prices increasing can push inflation to happen too. If a currency is dependent on certain goods and services for GDP growth, changes to pricing for their production or delivery processes can lead to inflation.

For example, if oil drilling is a significant source of revenue for a country, anything that causes higher costs associated the drilling process could cause inflation. This could be higher wages or increases in the cost of drilling equipment, for example.

Devaluation

Unlike the first two causes of inflation, which are caused by macroeconomic circumstances, devaluation is a decision made by the government to lower the value of their currency so it’s worth less than before.

An emerging market country may do this in order to make more money for itself by making its exports more attractive, generally increase international trade in and out of the country and also potentially lessen its national debt deficit. By making itself ‘cheaper’ through devaluation, they can attract more buyers for whatever exports they’re selling to the international marketplace.

However, devaluation often causes inflation. This is because other currencies haven’t changed their value, so the cost of importing goods is higher for that country than it was before, ultimately leading to its money being able to buy less.

Undersupply due to lack

Sometimes, literal scarcity can drive down the value of money. If, for example, a country is hit by devastating natural disasters or war, which makes basic items very hard to come by, then the price of these items will naturally rise. This consequently makes the money of that country worth far less, as it costs more to buy the same goods.

In these extreme situations, investor behaviour can also compound inflation. An example would be if a country’s citizens anticipate so much instability that they withdraw savings and other assets like gold, jewels etc and hoard these items to avoid losing them when a bank goes bust. This would also lead to a shortage of assets in an economy, further driving up inflation in a vicious cycle.

Oversupply of money itself

The opposite of the cost-pull scenario we mentioned earlier, this is when there’s more money circulating in an economy than there’s a desire to spend it. Several things could lead to this, like a decrease in taxes (meaning more cash in hand for citizens) or a widespread country culture of saving rather than spending.

As per the economic principles of supply and demand, the value of that money will go down if there’s a greater amount of money available in a financial system than there is a demand for it.

Built-in inflation

When any of the above causes of inflation persist for a long time, that becomes the country’s ‘new normal’. This leads what’s known as ‘built-in inflation’ – where the effects of inflation are part of a continuous cycle.

For example, prices of goods regularly rise and rise. As a result, the country’s working class demand higher wages to pay for the higher cost of living. This increases their disposable income, which leads to a rise in the demand for consumables – again increasing their prices. This is the most common cause of inflation today.

Extreme examples of inflation

While there are some positive side effects of inflation, there are times when it’s so extreme that it creates a snowball effect (called runaway inflation), which leads to a phenomenon called hyperinflation.

This panic, combined with excessive and unmanageably high costs of everyday goods, has left its mark on some of the most pivotal eras in the past century.

The hyperinflation in Germany, 1923

Germany’s currency, the deutschemark, had weakened drastically and the country was in considerable debt after the First World War. To make matters worse, political instability was rife and the country had come off the gold standard, which meant its currency was no longer backed by the reliable anchor of the current gold price. The precarious Weimar Republic started printed more money, hoping this would help.

By 1922, Germans had begun to trade goods in a kind of bartering system to avoid using the increasingly meaningless deutschemark. At hyperinflation’s zenith in 1923, one US dollar was equivalent to one trillion deutschemarks.

Germany’s hyperinflation in 1923 shows the potentially dire effects of runaway inflation. Many experts directly attribute the subsequent rise of the Nazi party in Germany to this climate of hyperinflation.

The 1973 oil crisis

After the Yom Kippur War in 1973, the countries of the Organisation of Arab Petroleum Exporting Countries (OAPEC, now known as OPEC, the Organisation of Petroleum Exporting Countries) retaliated by placing an oil embargo on the countries which had supported its adversary, Israel.

These included many of the most influential nations in the world, including the United Stated, United Kingdom, Canada, the Netherlands and Japan. Many countries imported the vast majority of their oil from OPEC, so this shock to the financial system led to runaway oil prices.

The embargo lasted for almost six months, during which the price of petrol increased by over 200%. Particularly in the United States, it was so volatile that the fuel price would sometimes change more than once a day. This led to significant inflation of household goods for American citizens and also had a domino effect on the global economy.

The 2022 Russian invasion of Ukraine

Shortly after the devastating effects of the Covid-19 pandemic, citizens of the Ukraine woke to the sounds of gunfire and explosives on 24 February 2022. Russia, under its president Vladimir Putin, had launched a full-scale military strike on the country.

Most of the international community imposed sanctions quickly to cut off any funding of the conflict. However, this also led to a spike in global inflation, as the rest of the world was deprived of the oil, grains, exported goods and roubles that Russia had previously supplied. The EU and in particular Germany was affected severely, being deprived of their vital gasoline pipeline Nord Stream 2.

With the invasion lasting more than eight months, this caused prices for petrol and diesel, as well as for most food stuffs and other household goods, to increase significantly throughout 2022 – hamstringing vulnerable countries just after the devastation of the pandemic and worsening poverty in developing economies.

Effects of inflation

1. Erosion of purchasing power
2. The poor become poorer
3. Interest rates rise
   

Erosion of purchasing power

Inflation means that the money used to buy items or services is worth less, and things effectively cost more than they used to. The same groceries, fuel or other items are more expensive, so people have to make that pound or dollar stretch that much further to meet their needs, reducing their disposable income and effectively their buying power.

The poor become poorer

It’s not all bad for those who own assets that appreciate in price when inflation hits. Things like property, certain stocks portfolios, pension funds and investments in some commodities often act as useful hedges against inflation – because of interest rate increases (see below), the value of these things rise with inflation, offsetting the fact that monetary value of cash itself has depreciated.

This means that those on the less wealthy side of the spectrum, who don’t own property or these sorts of investments, are always hit hardest by inflation. With the weaker purchasing power and the rising prices inflation brings, society’s poor unfortunately become even poorer.

Interest rates rise

As we’ve seen in our earlier examples of hyperinflation, too much inflation can have a devastating effect. To prevent this from happening, central banks will usually raise interest rates to curb inflation. They’ll use monetary policy to constrain the supply of money to drive the borrowing costs (ie the interest rate) higher.

There are a number of reasons for this. When inflation causes a currency to lose some of its purchasing power, the bigger money lenders such as banks will demand a raise in interest rates – the amount of interest which they are allowed to charge borrowers and the amount of interest they themselves pay back to the central bank – as compensation for the loss of worth in the money itself.

However, a more important reason is staving off further inflation. When interest rates go up, loans, mortgages and other forms of bonds become more expensive. This curbs too much borrowing, and therefore too much spending. This leads to consumers buying less or cheaper where they can, which aims to drive down the prices of these goods – thereby keeping purchasing power in check.

How to measure inflation

There are two different ways to measure inflation: the first is CPI (consumer price index) and the second, lesser used one, is RPI (retail price index). While other methods do exist, CPI and RPI are the most common.

With CPI, inflation is measured by looking at the current price of consumable goods in shops as compared to what the same items used to cost.

While this is some indication of inflation, RPI is more comprehensive, as many things affected by inflation aren’t on shelves in stores (for example property prices, the cost of services and more.) While CPI focuses on consumables, RPI also measures the difference in the retail prices of things such as property prices, mortgage interest rates and insurance premiums.

Both RPI and CPI measure inflation by looking at the rate of increase of prices under their purview. While RPI is more broad and takes into account more than just store goods, CPI is more inclusive. This is because a smaller percentage of most populations tend to have properties, insurance and investments.

Advantages and disadvantages of inflation

How inflation gets controlled in the UK

How inflation is controlled will vary from country to country, but in the United Kingdom, that responsibility rests with the Bank of England (BoE), which is the UK’s central bank.

The way that the BoE does this is by use of monetary policy – the agreed-upon set of financial rules that’ll control a nation’s supply of their currency and how much it costs banks in the UK to borrow from the BoE, which is known as the ‘bank rate’.

When the BoE changes the bank rate or the interest rate, it’s usually as a result of inflation. Raising interest rates will help to keep higher inflation in check by encouraging saving instead of spending on credit, while lowering interest rates will ease a slow growth environment by encouraging spending and employment.

How to hedge against inflation

While inflation causes some types of assets (such as cash, the actual unit of money in that country) to depreciate, other types of investments or trades can perform well.

Hedging means opening a trade or investment that you think will be profitable to mitigate short-term losses of an existing position you have open without your having to close it. Hedging against inflation, therefore, means opening a trade or investing in an asset class known to perform well when inflation rises, so as to offset any inflation risk.

Find out more about hedging

Some of the better-known ways hedges against inflation include gold, real estate investment trusts (REITs) and certain types of bonds, eg UK index-linked gilts. The hope is that either trading or investing in these and other assets that appreciate during times of inflation will offset any other losses inflation may cause you.

Find out more about how gold affects inflation

Another way to hedge against inflation is to trade directly on interest rates using our platform. This can be highly effective, as rates closely follow and are linked to inflation. With us, you can use spread bets or CFDs to speculate on what the interest rate will do in various money markets (including the UK’s) without having to take ownership of any cash itself, which decreases in value during increases in inflation. If you choose to do this with us, we’re the No.1 CFD provider in the UK.¹

Find out how to hedge against inflation

What’s inflation risk?

Inflation risk is the chance that uncontrolled inflation, arising from macroeconomic circumstances rather than deliberate monetary policy changes, will lessen the purchasing power of that country’s money, raising the risk that the worth of any investments or cash you own will be eroded.

Learn more about inflation risk

How inflation impacts wages

In most countries, the service sector is a significant contributor – if not the largest industry outright – to an economy. For this reason, how high or low wages are set very much affects inflation.

When workers are paid more, the cost of industries’ spend goes up as they have to pay higher wages. This can often cause inflation – known as ‘wage push inflation’, because it’s that much more expensive for industries to do business.

However, this can quickly lead to a vicious cycle if left unchecked. That’s because, if higher wages leads to higher inflation, this will in turn mean more expensive goods and services. When these prices rise, workers tend to demand higher wages to keep up with the increasing cost of living.

Inflation summed up

• Inflation is the decreasing of money’s purchasing power as the cost of consumables like goods and services rises
• This makes a country’s unit of money worth less, effectively, as you can buy less with the same amount
• This results in the poor becoming poorer, although some assets like property, some bonds and commodities can appreciate in value
• Inflation is caused either by macroeconomic factors, like the supply and demand for money, or by a central bank’s monetary policy
• You can hedge against inflation. This is when you trade or invest in markets, like gold and real estate, that tend to appreciate in value when inflation rises
• With us you can trade on interest rates directly to hedge against inflation, using spread bets or CFDs
  

Footnotes

¹ Based on revenue excluding FX (published financial statements, October 2021).