What Causes Inflation?

Inflation has been one of the bugaboos of 2022, driving up prices around the country and wreaking havoc in everything from consumer budgets to stock market prices.

Since inflation has been relatively low for decades, many Americans are wondering exactly what causes inflation, and why has it come roaring back so hard in 2022? The reasons are complicated, but can be broken down into broad strokes: rising demand, diminishing supply and expansionary fiscal and monetary policies have all played a role. Read on for more detailed information about the causes of inflation, particularly how they relate to 2022.

Rising Demand

One of the classic definitions of inflation is “too much money chasing too few goods.”

A perhaps more accessible version of this axiom is that when customers demand more of a product than exists, its price goes up. That’s a simple economic concept that makes a lot of sense if you look at things from the perspective of a business owner. Imagine that you produce a popular product that keeps selling out, one that you can never keep in stock in your inventory, no matter how much you produce. The prudent course of action in this case is to raise your prices.

Demand-pull Inflation

Now, imagine a booming economy in which consumers are flush with cash and buying everything in sight, depleting inventories across a number of industries. Prices will naturally rise across the board, resulting in widespread inflation.

This type of economic environment is known as “demand-pull” inflation, as the demand for goods and services is pulling prices higher in the economy at large.

Demand-pull inflation can also appear even if, strictly speaking, demand isn’t particularly high. Anything that puts the supply/demand equation out of balance will result in demand-pull inflation, so even if demand isn’t off the charts, if supply is limited, the same effect can occur.

Supply chain shortages have made headlines in 2022 as many products, from cars to computer chips, have not been able to keep up with demand. This is one of the many contributing factors for high inflation in 2022.

Rising Costs

In addition to supply and demand being out of balance, rising costs are another major contributor to inflation.

Cost-push Inflation

Known as cost-push inflation, rising prices can drive up the cost of production for businesses, which must ultimately pass those costs along to consumers in the form of rising prices — thereby creating inflation.

What costs do employers face? There’s quite a long list actually, and each component can contribute to inflation. Over time, most employers have to pay out rising wages, and sometimes dramatic increases can be forced upon them by government decree. California, for example, was one of the first states to push its minimum wage to $15 an hour — well above the federal requirement of $7.25 an hour — and as of 2023, it will tick even higher, to $15.50 an hour.

Employers also have to deal with the rising cost of benefits, from 401(k) fees to health insurance, and this is on top of the expense of the raw materials some businesses require, from oil to copper to countless other raw materials costs.

At the end of the day, as the cost of doing business rises, so too does the cost of the goods and services that businesses provide. Ultimately, this translates into consumer inflation.

Contributors to Rising Inflation

Beyond rising employer costs and supply and demand issues, there are a number of macroeconomic factors that play a role in rising inflation. Two of the most prominent of these are fiscal and monetary policy.

Fiscal Policy

Fiscal policy refers to how a government handles things such as taxation and spending to influence consumer activity and the economy overall.

Probably the most noteworthy example of fiscal policy influencing inflation in recent times has been the massive stimulus packages handed out by the government starting in 2020. Primarily in the form of stimulus checks and forgivable business loans, the trillions of dollars in stimulus distributed by the U.S. government most likely played a role in triggering the inflationary pressures seen in 2021 and 2022.

Monetary Policy

Monetary policy refers to the actions of central banks, like the U.S. Federal Reserve, to control the money supply. When the Fed lowers interest rates, as it did at the onset of the COVID-19 pandemic in 2020, it creates an expansionary monetary policy, which increases the money supply and makes it cheaper for both businesses and consumers to operate.

However, when monetary policy is left in an expansionary position for too long, inflation is prone to rise. This is the battle the Fed is currently waging in 2022. After years of interest rates near zero, inflation has shot up to its highest level in over 40 years, prompting the Fed to aggressively raise rates to keep inflation in check.

Of course, the Fed can often overshoot its mark and leave monetary policy too tight for too long, which can result in a recession. This is the fear that many economists have as we head into 2023.

Who Benefits From Inflation?

Rapid gains in inflation tend to be harmful for everyone, as they generally lead to out-of-control prices and a recessionary economy. However, modest levels of inflation can benefit many.

• Companies can charge higher prices in a slightly inflationary economy, potentially leading to higher profits and better returns for investors.

• Those with large, fixed-rate loans, such as home mortgages, benefit from rising inflation as they are paying their housing costs with more valuable dollars.

• Investors holding Treasury Inflation-Protected Securities, or TIPS, can also benefit from increased returns in an inflationary environment — but you should speak with a financial advisor to fully understand these complicated securities.

The Bottom Line

Inflation is a complicated economic concept that results in higher prices for goods and services. The federal government generally keeps inflation to a relatively narrow range, based on a combination of fiscal and monetary policy, but as the business cycle ebbs and flows, it tends to push up or drag down inflation along with it.

Understanding how the cycle works can help you better deal with inflation in your personal finances.

FAQ

Here are some quick answers to common questions about inflation.

• What is the main cause of inflation?

  • Supply and demand imbalance and fiscal and monetary policy play a significant role in causing inflation.

• What is causing the inflation in 2022?

  • A major cause of inflation in 2022 is the supply chain issues caused by the COVID-19 pandemic –as goods became scarce, prices went up in response to continued demand.

  • The stimulus checks and loans provided by the federal government also played a role, as well as long-lasting low interest rates.

This article originally appeared on GOBankingRates.com: What Causes Inflation?