How bad is the situation ?: You need to know about inflation

It disappeared from Germany for years, now it’s back: inflation. Electricity is becoming more expensive, as is going to the hairdresser. How dangerous is that has the answers to the most important questions.

What is inflation

Inflation is a general, average rise in prices. It is perfectly normal for prices to change in a market economy. Some rise, some fall. If the rolls at the bakery around the corner or the haircut at your favorite hairdresser get more expensive, that is not yet inflation. Only when not only the prices of individual goods and services rise, but also the prices in general, does one speak of inflation.

How is inflation calculated?

To do this, statisticians look at the prices of all goods and services that households typically spend money on. This is the so-called shopping basket that is created in Germany by the Federal Statistical Office. This includes 650 types of goods – from bottom-fermented beer to pets. In order to calculate the average price increase, the products in the shopping cart are weighted differently. This means that things that are spent more on (e.g. rent) are weighted more heavily than things that are spent on less (e.g. hearing aids). From this the “consumer price index” is calculated every month. The change compared to the previous year or the previous month is the inflation rate.

How high is inflation now?

In September, consumer prices in Germany rose by 4.1 percent compared to the previous year, the highest they have been for almost 28 years. The statisticians last determined a four to the decimal point in December 1993. According to the EU statistical office Eurostat, inflation in the euro zone was 3.4 percent. To put it into perspective: inflation was low for many years. Last year the rate of price increase in Germany was 0.5 percent, compared to 1.4 percent the year before.

What is the aim of the European Central Bank?

The ECB changed its inflation target in the summer. Since then, she has seen price stability achieved when consumer prices in the euro area rise by two percent in the medium term. This is a slight increase in the inflation target, which was previously “below but close to two percent”. The ECB sees this goal as “symmetrical”. In other words, for the central bank an inflation rate that is too low is just as negative as an inflation rate that is too high.

Why are prices stable at two percent and not zero percent inflation?

In a healthy economy, prices tend to go up. If the economy grows, so does income and expenditure. Two percent is a largely common target at which price stability is considered to have been achieved. The basis for this is not an exact calculation. Rather, it is about not setting the goal too high or too low. The ECB wants to keep a safe distance from deflation, i.e. avoid permanently falling prices. It also takes into account the fact that slight measurement errors can occur. A measured inflation rate of zero could indicate a slight decrease in the actual price level. In addition: the euro zone has 19 members. There are countries with higher and countries with lower inflation rates. If the ECB were to aim for an average price increase of zero percent, some member states would have to show corresponding negative rates in order to offset the price increase in other countries.

What is so unpleasant about deflation?

If the population thinks prices will fall across the board, they hesitate to spend. For example, anyone who expects a new television to be much cheaper in four months will not buy it until then. If overall economic demand falls as a result of this waiting, prices will tend to fall further. A vicious circle looms that is more difficult to fight with monetary policy than inflation. For companies, falling prices mean their revenues fall. Savings, layoffs or even bankruptcies can be the result. In addition, deflation means that debts are getting bigger and bigger in real terms. Just as inflation devalues ​​debt, deflation increases the debt burden. Consumers and companies therefore shy away from taking out loans in a deflationary environment. Deflation is poison for the economy.

Why have prices risen sharply lately?

There are several reasons for that. These are the most important:

1. At the beginning of the corona pandemic, the global economy collapsed. Among other things, this led to falling prices. But the economy has been recovering for a few months now – consumers are spending more money, companies are producing and investing more. The increasing demand leads to rising prices and thus to inflation. Price increases are made easier by the fact that consumers saved money in the corona lockdown – for example through unusual vacation trips and restaurant visits.

2. The fact that inflation rates are currently so unusually high is also due to the fact that they were so unusually low a year ago. A comparison shows how strong this so-called base effect is. In August the prices were around 3.9 percent higher than in the crisis year 2020. They were, however, also 3.9 percent higher than in August 2019. That means: Compared to the pre-crisis level, the prices rose by just under 2 percent per year.

3. The global supply chains are disrupted. One of the reasons for this is that during the corona pandemic, many companies have significantly reduced their production and personnel capacities. The recovery came surprisingly quickly, and it takes time to start up – among other things because people have been laid off, they have reduced their working hours or are looking for another job straight away. That means: The demand for products rises faster than the supply, which leads to rising prices. In addition, the corona pandemic has shaken up global delivery routes in container shipping, with traffic jams in front of many ports. There is also a shortage of containers. The result: the bottlenecks make transport more expensive.

4. The economic boom and the delivery difficulties after the Corona recession are leading to downright hamster purchases by companies around the world. They are trying to replenish their stocks. Since this happens around the world, it also increases prices.

6. In Germany, inflation is also fueled by a statistical special effect. In the second half of 2020, the federal government lowered VAT rates to stimulate the economy in the pandemic. As a result, prices even fell at times. The usual rates have been in effect again since the beginning of the year. In other words, the inflation rate will rise in the second half of this year, as the goods and services that have become cheaper as a result of the tax cut are used as a benchmark.

Which prices are rising particularly sharply?

Above all, energy is becoming more expensive. Oil is more expensive than it has been in seven years. In the course of the economic recovery, coal and gas prices have also risen significantly. In Germany, the CO2 tax that was introduced at the beginning of the year also contributes to this.

Hasn’t inflation mainly to do with the expansion of the ECB’s money supply?

Barely. The notion that loose monetary policy inevitably leads to high inflation has proven wrong in recent years. Since the financial crisis in 2006, so-called central bank money, i.e. the central bank balances of commercial banks in the euro zone, has risen sharply without causing high inflation. This is due to the fact that the decisive amount of money M3, which includes the money actually in circulation, is growing only weakly.

How dangerous is high inflation?

To answer this question, the think tank “Department Future” recommends between (harmless) temporary attacks and (dangerous) permanent spirals to distinguish. In spurts, the price trend stabilizes again as soon as production catches up with demand. On the other hand, permanent increases in inflation are problematic.

The classic for such a development is the wage-price spiral, when very low unemployment meets very high aggregate demand. The logic: workers can enforce higher wages across the board, whereupon the companies raise prices in return, whereupon the workers enforce higher wages, a chain reaction occurs and inflation does not return to the green on its own.

And then?

Then the central bank has to intervene and raise interest rates. As a result, loans are becoming more expensive. Plus, it’s more worth putting money aside. This means that consumption and investment tend to decline – and with it economic growth.

So is the sharp rise in inflation only temporary or is it long-term?

That depends on whether the main reasons that are currently shaping price developments are limited in time – or not. Most experts assume that inflation will slow down again. The ECB expects inflation of 1.7 percent for the coming year and 1.5 percent for 2023. The fact that the increase in value added tax or the introduction of the CO2 tax were one-off effects speaks in favor of a fall in the rate of inflation. Capacity bottlenecks and supply chain problems are likely to be overcome at some point. The question, however, is when that will be the case.