How to think about inflation

In this post I discuss how to think about inflation. This a topic which routinely captures a lot of media attention, especially given the roller coaster inflation has been on in the last 3 years. Along with this attention, comes a lot of misunderstanding of what inflation is, what causes it, and how it should be controlled. This post will hopefully clarify these concepts.

To really understand this issue there are a couple principles which need to be understood. First, what is the difference between inflation and the price level? Second, what is the difference between relative prices and the price level. Much confusion about inflation can be explained by confusion about the definition of these, as pointed out by John Cochrane.

The first question is what is inflation? This might seem obvious, but inflation is the growth rate of general prices within an economy. This is different from the price level. The price level refers to the overall average level of prices at a given time, while inflation measures the rate of change in the level over time. The average level of prices in the economy is typically measured by a government agency, who go out and survey the price of 1000’s of goods and services around the country. In Australia, that job is performed by the Australian Bureau of Statistics (ABS) which measures prices at a monthly level (although every quarter they do a more detailed survey). The ABS then create a price index which tracks the average price of goods/services over time. This is a measure of the price level. The rate of change in the price level (typically measured as the rate of change from 12 months prior) is the inflation rate. When the level of prices is increasing, this is referred to as inflation. If the level of prices is decreasing, this is referred to as deflation. If the rate of inflation is falling, this is referred to as disinflation.

The most widely known measure of inflation is the headline Consumer Price Index (CPI). This includes the rate of change of prices of a representative basket of goods and services (that a consumer would typically purchase). Now all of us spend our money differently, which means that each of us has our own personal inflation rate that we experience. The headline CPI reported by the ABS is the inflation rate on a hypothetical basket of goods/services that is meant to represent the average household (the hypothetical basket does change over time, more details can be found here. There can be different measures of the price level and inflation rate, depending on what prices you decide to include or exclude. For example, the ABS also computes a trimmed mean CPI, or “Core” CPI, which excludes volatile prices like petrol and groceries. The reason being that the prices of these goods are typically driven by global commodity prices, something the central bank cannot control. The trimmed mean CPI gives a “cleaner” measure of the underlying inflation in the economy.

The second key idea is the difference between relative prices and the price level. Relative prices are a measure of the relative prices between two goods, say apples and petrol. Relative price changes occur when one specific good, like petrol, becomes more expensive compared to the price of apples and vice versa. Rising petrol prices alone, are not necessarily a sign of inflation, but indicate a relative price change compared to the price of other goods. Inflation involves a simultaneous rise in the price of all goods and services across the economy, maintaining the same relative price among all goods and services. This leads us to our first takeaway, a price rise in one good or service, is not always a sign of inflation (I’ll explain why below). In true inflation, all goods and services—including petrol and apples—would rise roughly proportionally, preserving their relative price relationships. Inflation is thus a broad monetary phenomenon, not just a summation of individual price increases. Let’s look at the implications of relative price changes. A rise in one sector’s prices (e.g., petrol) will typically lead to a price decrease in other goods. Think about it this way, I have $100 of income to spend between apples and petrol. If the price of petrol goes up this month, I have less money left to buy apples (at least in the short run this is true unless someone gives us more money, i.e. the government through fiscal or monetary policy). Demand and therefore the price of apples will fall. A change in relative prices, all else equal, will keep the overall price level constant, as the price increase of any one good is offset by price falls in the other goods.

This leads to our second takeaway, something that drives a change in relative price, does not cause inflation (on it’s own). For example, the favourite bogeyman of the media is corporate price gouging. If a firm rises the price of a good (beyond some reasonable level relative to costs), this is decried as the root cause of inflation. If only governments could stop firms raising their prices, then inflation could be solved, right? Wrong. It’s the same fallacy as described above. A change in relative prices, means that if the price of one good goes up because a firm is price gouging, leaves consumers with less money to spend on other goods (at least in the short run), keeping the overall price of goods constant. Price gouging can explain changes in relative prices, but it cannot explain inflation across all prices.

So what drives the general price level of all goods and services up simultaneously? In any economic system there must be some force that acts as a reference point or stabilizer for the general price level. In economics there are two such theories which could explain why all prices would move higher, Monetarism and Fiscal Theory of the Price Level. According to Monetarism (of which Milton Friedman was a proponent), the price level is anchored by the supply of money. If the government (through fiscal policy or monetary policy) decides the print a pile of currency and hand it out to people in the form of stimulus checks, consumers will immediately spend that money, bidding up the price of goods and services. This will generate inflation. According to the Fiscal Theory of the price level, government debt’s real value anchors prices. Without a change in the nominal anchor (e.g., more debt or money creation), relative price shifts (e.g., petrol vs. apples) don’t cause overall inflation.

What about supply shocks? Can supply shocks explain inflation? The answer is it depends. For example, if a global pandemic makes it hard to import goods, e.g. Televisions, then the price of these goods will rise. Further compounding this, is lockdowns mean people can’t go out, and instead may buy more televisions instead. But this supply shock is another example of a change in relative prices. If the price of televisions goes up, consumers have less money to spend on other goods, so some other good has to fall in price. So far no inflation. But a supply shock can cause inflation, if monetary and fiscal policy respond to the supply shock. If governments give consumers more money in response to the supply shock, then they will be able to pay the higher price for the televisions without sacrificing spending on other goods. This will lead to inflation. Thats exactly what we saw in 2021 and 2022.

The same logic can be applied to the impact of tariffs on inflation. Will the introduction of tariffs increase the price of some goods (particularly imported goods), yes. That’s a change in relative prices. Unless fiscal or monetary policy provide money, the prices of other goods may fall, leaving overall inflation unchanged.