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3 Keys to Understand Inflation

Entendiendo la inflación

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With rising gas prices, food costs, rents and even utilities, many Americans are wondering what is going on. The U.S. experienced its largest price increase in 40 years. This phenomenon is known as inflation, which is defined as the loss of purchasing power of money. El American gives you 3 keys to understand what inflation is and what causes it.

1. What is inflation?

The price of any good or service rises because of excessive demand relative to supply at a given time and place. Inflation is a generalized increase in the prices of all or most goods and services as a result of excess demand.

Inflation is usually caused by an abnormal increase in the amount of money in circulation. To stimulate the economy, governments usually incur higher government spending or issue money to encourage private spending.

In theory, this money emission, done through loans from the Central Bank to commercial banks that then funnel the money to the public through credit at lower rates, stimulates demand for products, which in turn incentivizes employers to hire more people and thus produce more goods and services.

The problem occurs when people’s demand exceeds the economy’s production capacity so that the price of goods ends up rising.

When the situation described above arises, the economy’s response capacity to increase the supply of all goods and services in the short term may be very limited, since there is little unemployment and little idle productive capacity. This means that the only way to slow or decelerate price increases is to restrict demand.

If the government is unwilling or unable to reduce the fiscal deficit, the only mechanism to reduce nominal demand is to force banks to raise interest rates on loans to businesses and households. This is done by making the central bank’s credit to private banks more expensive.

The capacity of a private bank is limited by the number of reserves in legal currency that it is required to have at all times, which depends on the credit granted by the central bank. When the central bank raises the interest rate at which it grants credit, private banks, sooner or later, are forced to raise the rates at which they lend to their clients, otherwise, they would incur losses. 

Some customers will cease to demand credit and others will reduce their volume. Since credit is requested to buy goods and services, its reduction, which is expressed in a reduction of deposits in checking and savings accounts, implies a decrease in nominal demand and thus a lower rise in prices. 

2. Supply-side inflation

Inflation can also occur when there is a decline in goods and services crucial to the rest of the economy such as fuel, natural gas, or shipping.

During 2021, this occurred at a time when companies were reopening as lockdowns ended and U.S. consumers were demanding at record levels due to pockets fueled by subsidies in the pandemic and near-zero interest loans from banks.

In addition to inflated demand, there was also a supply chain crisis, which began with the blockage of a ship in the Suez Canal – an important hub for maritime trade between Asia and Europe – and was then magnified by the COVID-19 closures in several port cities in China.

In 2022, inflation was exacerbated by Russia’s invasion of Ukraine, which represented a partial halt to international trade in goods such as wheat, barley, oil, and natural gas.

Without sufficient fuel, vehicles cannot transport products to supply points; without gas, households cannot heat, nor can companies obtain cheap energy; without wheat, bread, tortillas, and other products cannot be made.

The shortage of some goods and services, mainly raw materials, ends up creating shortages in the supply of other goods of higher added value, which in turn triggers a wave of inflation throughout the economy.

3. How is inflation controlled?

By raising interest rates, the Fed hopes to partially control the rise in prices that the U.S. is experiencing at the moment, however, the measure has a trade-off: it will make the cost of borrowing more expensive for all Americans.

Home loans are largely based on the 10-year yield on Treasury bonds. This rate is used as a benchmark for various types of loans. With the Fed raising rates, the interest on a 30-year loan has just risen to 4% for the first time since 2019. In 2021, the average rate on a home loan was 3.05 %.  

In recent years, lowinterest rates coupled with low inventory have pushed home prices upward. As of January, the average price of a single-family home in the U.S. was $357,100, an increase of 16% in less than a year.

It will be more expensive to pay off your credit card

Perhaps credit cards are among the first financial instruments to experience a rise in interest rates. Normally, before the rise in interest rates, it is ideal to pay your debts with your credit cards, since the cost of the debt will become more expensive as the FED raises interest rates.

Although banks have complete independence in deciding the interest rate charged on the credit card loans they offer, the interest they charge is largely determined by the Federal Funds rate, i.e., if the interest rates set by the Fed go up, the interest on credit cards will almost automatically go up.

For Americans who pay their debts at the end of the month, the change will not be much, however, for those who owe large amounts of money on their credit cards the change could be significant. During the last quarter of 2021, credit card debt in the U.S. grew by $52 billion, and the average American’s credit card debt is $5,525.  

Auto loans come with a fixed interest rate indexed to U.S. Treasury yields. This means that the cost of financing credit for new drivers will not become more expensive with an interest rate hike by the Fed.

Unfortunately, this is not the same for those who are just thinking about buying a car, as the interest rate for new loans is subject to change. The financing conditions for the purchase of the vehicle may vary depending on the dealer or bank where the loan is requested. The average rate for a five-year auto loan is 3.98% annually.

Economist, writer and liberal. With a focus on finance, the war on drugs, history, and geopolitics // Economista, escritor y liberal. Con enfoque en finanzas, guerra contra las drogas, historia y geopolítica

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