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Inflation – Friend or Foe

July 12 2022

Inflation, the oil for the economic engine

One of the main macroeconomic concerns today is inflation. For most of 2021, monetary authorities argued that inflation will be transitory and so, as a result, they felt that adjusting monetary policy was not required. However, in 2022, under the pressure of accelerating inflation on the back of higher commodity prices impacted by the war in Ukraine, monetary authorities were forced to adjust their policy and start raising interest rates.

Why are we and financial markets so worried about inflation? Inflation is like the motor oil in a car in that to drive smoothly the engine needs oil.  However, too much or not enough oil creates problems and potentially prevents the engine from running. Interest rates as the ‘price of money’ are closely correlated with inflation and rise when inflation picks up to avoid declining or negative real interest rates (interest rates minus inflation).

Rising prices on the demand side reduce disposable incomes, hurt consumption, and creates demand for higher wages. As soon as interest rates start to rise, these effects are exacerbated, which puts further pressure on demand. Apart from being impacted by reduced demand, the supply side experiences pressure on margins by increasing input prices (commodity prices, material prices etc.) depending on how much of the higher prices can passthrough to the end consumer. Furthermore, wage increases, and rising interest rates put extra pressure on corporate earnings. A scenario of rising inflation and interest rates jeopardizes economic growth and can ultimately lead to a recession. Monetary authorities play a key role in managing this process primarily using interest rates to control demand and indirectly prices. However, since interest rates are a very blunt tool that only indirectly impacts inflation with a time lag, it is a very delicate strategy, comparable to steering a large oil tanker.


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