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What causes inflation and deflation?

10 June 2020

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by Anchor

Inflation is when prices of goods and services rise. Conversely, deflation (or negative inflation) occurs when the prices of goods and services decline, and the inflation rate falls below 0%. Both can be damaging to a country’s economy, depending on the underlying reasons and the rate of price changes. While we focus on inflation and deflation in this note, there is also stagflation. Stagflation is continued high inflation combined with weak, or negative, economic growth, high unemployment, rapidly increasing prices, and a stagnant economy. In the developed world, stagflation was last experienced in the mid-1970s when the Organisation of Petroleum Exporting Countries (OPEC) cut oil supply, sending prices soaring.

The main causes of inflation are i) excess aggregate demand or when demand grows faster than supply; ii) cost push (supply-side) factors, where raw material costs rise, for example, higher oil prices will result in higher costs for businesses which are then passed on to consumers in the form of price increases; iii) increasing costs of imported goods due to rand weakness, meaning that you pay more to buy the same imported goods because of the weaker currency; iv) where trade unions demand higher salaries, which in turn increases business costs and the disposable incomes of consumers (an example of this in SA is the public sector wage bill, where YoY remuneration in government has outpaced the average inflation rate by c. 2 ppts p.a. since 2006, which is unsustainable); v) the expectation of higher inflation which manifests in workers demanding higher salary increases and firms pushing up their prices as a result; and vi) higher taxes, where a government increases VAT and/or excise duty, this leads to higher prices and consequently increased inflation.

Various factors can cause deflation with the most obvious being i) a drop in aggregate demand, resulting in a price decline of goods and services – more supply, less demand; ii) when a country’s central bank (the Reserve Bank [SARB] in South Africa [SA]) raises interest rates, people will in most instances prefer to save their money rather than spending it as increased rates lead to higher borrowing costs, which discourages spending; iii) a drop in confidence in a country’s government or an event such as a recession can result in lower demand – as people become more negative about a country’s economic future they spend less and save more; and iv) a fall in input prices (e.g. the recent drop in the oil price), which lowers production costs – manufacturers can increase production which could lead to an oversupply in the economy and if consumer demand does not also rise, producers will have to lower prices to stimulate sales.

Technology and demographic trends are also two big contributors to inflation and deflation. The jury is still out on whether quantitative easing (QE) causes inflation. It will likely only result in inflation if it finds a way to increase the velocity of money (M3) via a simultaneous increase in credit. Supply chain disruptions are also a potential source of inflation that may be relevant to the current environment as are trade tariffs, although much like VAT hikes, those tend to be transitory.

In SA, inflation is tracked by Statistics SA (Stats SA) using the Consumer Price Index (CPI), which measures monthly price changes (which records the rate of inflation) on a basket of consumer products and services.

Not all South Africans use the same goods or services (or consume these goods and services in the same quantities), which means that CPI cannot measure the way individual households experience inflation or spend their money. Consequently, Stats SA bases the inflation rate on the estimated total expenditure of all SA households. Stats SA uses two criteria to decide what goes into its CPI basket – total expenditure on the item and the number of households purchasing such an item. This is done to ensure that, for example, expensive items which only a few households buy (such as musical instruments, boats, etc.), or items that are purchased regularly but are so cheap that their weight would be insignificant in the basket (e.g. matches) are not included. According to Stats SA, it has permanent staff appointed as price collectors, who visit sampled outlets and markets on a monthly basis to record actual prices on the shop floor.

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