By Charis Mountis, Head of Dealing at ForexTime Limited

We all understand what inflation means in practical terms: goods increase in price over time. That’s why the amount of money that was needed to buy a new house in the 1960s can barely buy a new car today. It would seem, perhaps, that if we could all agree to keep prices at a constant level we wouldn’t have to deal with the headaches and problems of rising prices. Yet, most central banks around the world try to maintain an inflation rate of two percent—not zero percent. Why does inflation matter and why do central banks set inflation targets?

Why Inflation Happens

Get a group of economists together in a room and they are certain to start debating the causes of inflation faster than you can say ‘rising prices’. Although economists may not agree on the specific reasons that drive each case of inflation around the globe, there are two general guidelines we can use to understand the main causes of inflation:

• Demand-Pull Inflation – when consumer demand outweighs supply, prices increase. Inflation occurs when demand increases faster than supply for a large number of consumer goods or services, not just one or two isolated cases.
• Cost-Push Inflation – when production costs rise, prices increase in order to maintain the level of profits of the producer (or service provider). Costs can grow as a result of an increase in the price of imports, arise in oil, water, or electricity prices, a tax rise, etc.

Given the multitude of factors that can affect demand and supply and the production chain of goods and services, maintaining prices steady at all times becomes impossible. No legislative body can accurately predict or control the appetites and outputs of the market. Prices therefore fluctuate, causing inflation when they rise and deflation when they fall.

The Purpose of Inflation Targets

Although consumers may see inflation as a bad thing, since it drives prices up, the truth is that a little inflation can be good for the economy. When the prices of goods and services increase, company revenues grow, and increased revenues lead to salary raises and the creation of more jobs. The psychological boost of increased salaries encourages consumers to spend money on the goods they want and keeps the economy flowing and growing.

When the prices of goods remain stable or even worse fall, things may not be as positive as they appear to consumers who may only see the short-term benefits of non-increased prices. When prices don’t change but the costs of production increase, the profits of the company providing the goods or services decrease. And when companies are faced with shrinking margins, they take measures to compensate for their losses by withholding salary raises or even cutting salaries or jobs when things get dire. This has a negative effect on the psychology of consumers who stop spending money as freely as before, fearing impending financial difficulties. What’s more, small increases in prices urge consumers to buy goods now, before prices go up later. Steady or falling prices, however, only encourage consumers to wait longer before making big purchases, which further restricts the flow of money in the market and hinders economic growth.

By the same token, too much inflation can also slow down economic growth. High inflation begins eroding the value of gains for corporations because the purchasing power of money decreases dramatically. Moreover, with prices rising uncontrollably and without consistency, it’s hard to know whether increased revenue comes from additional demand in the market or simply from higher prices. Consumers spend more freely and save a lot less, since the value of savings quickly diminishes.Aggregate demand, moreover, quickly outstrips supply in such cases,pushing prices even higher and the value of money even lower.

Experience and studies have taught central banks that in order to maintain their economies’ growth at a healthy rate, they need to maintain inflation at around two percent. When inflation falls below that level, or turns to deflation, problems of unemployment and economic stagnation arise. When inflation rises too much over that two percent level, currency devaluation and uncontrollable prices wreak havoc on the stability of the economy.

The economy is not a fixed and stable entity, but rather a dynamic process that needs to maintain a delicate balance in order to move forward. We could think of the economy as a bicycle in motion and inflation rates as the speed by which that bicycle is travelling. When the bicycle remains static, or if we try to backpedal, we’ll soon lose our balance and fall. Similarly, when the bicycle travels at an excessively high speed, it becomes hard to control and manoeuver through the ups and downs of the road ahead. But when the bicycle has a steady, controlled pace it’s easy to maintain balance and create forward momentum.

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