There has been much hype recently about rising inflation rates around the globe. The euro zone had an inflation rate of 2.2% in 2010, while China's rose 5.1% from November 2009 to November 2010. Many people fear that a surge in inflation could have an adverse effect on the recovery efforts of many economies. But what exactly is inflation and how does it affect an economy?
Basically, inflation is the rate of change of prices for goods and services. To measure this, economists use either the Consumer Prices Index (CPI) or Retail Prices Index (RPI). Each index looks at the prices of thousands of common goods, from the cost of a postage stamp to the price of a big screen television. Items are weighted depending on of how much the average consumer spends on them; fuel affects the rate much more than stamps do for instance. These indexes display the inflation rate as a percentage, a 2% inflation rate means that the price of goods and services has increased by 2% compared to the previous year. The difference between the two indexes is that the RPI also contains prices on housing costs such as mortgage payments and taxes related to owning a home.
Why is this important to an economy? The inflation rate is used by the government and businesses in numerous ways. It plays a crucial role in a nation’s monetary policy. The most important function that it plays is setting interest rates. Governments increase interest rates if they are trying to subdue rising inflation rates, and lower interest rates when inflation is low. Inflation is also a crucial factor in determining employee income. Some companies use inflation rates to determine annual pay rises, and many benefits such as pensions are linked to the indexes.
Inflation affects everybody, from the national level all the way down to individual households.
Inflation is likely to remain elevated. Price gains this year will average 3.9 percent in advanced economies and 5.9 percent in emerging market and developing economies, before subsiding next year, according to our January World Economic Outlook update.
Assuming inflation expectations remain well-anchored and the pandemic eventually eases its grip, higher inflation should fade as supply chain woes ease, central banks raise interest rates, and demand tilts more toward services again instead of goods-intensive consumption.
Oil futures contracts indicate crude prices will rise about 12 percent this year as natural gas prices climb about 58 percent. Such increases for both commodities would be considerably less than their gains last year, and would likely be followed by falling prices in 2023 as supply-demand imbalances ease further.
Similarly, food prices are likely to climb at a more moderate pace of about 4.5 percent this year and decline next year—after a rise of 23.1 percent last year, according to the United Nations Food and Agriculture Organization. This should ease spending pressures for millions of people around the world, especially in countries with lower incomes.
Such burdens fall most heavily on residents of emerging and low-income nations, where food typically makes up a third to half of consumer spending. That share is smaller in advanced economies, such as the United States, where food accounts for less than one-seventh of household shopping bills.