IC Markets

What is healthy inflation?

In recent years, the topic of inflation has become popular again, and in recent months, numerous articles have been written about it on a daily basis. Many people envision a globally persistently higher inflationary environment compared to the previous decade. Inflation is an important phenomenon for people in terms of living costs, and it is equally important for an investor. In our current 5-part blog series, we will explore the essential topics related to inflation, without stretching each part, as the goal is not to create noise or delve too deep, but rather to provide a good overview of the topic.

In the previous part, we discussed some general characteristics of inflation, and now we would like to delve a little deeper. When we talk about the inflation numbers of different countries, we always refer to the official average inflation rate calculated for consumer baskets. It turned out in the previous part that there might be different phenomena observed in individual products or consumption habits, but long-term trends mainly focus on general consumption.

As for the long-term trends, perhaps only one thing is certain: the rate of inflation is constantly changing. This depends on a number of factors, perhaps the most important of which are:

  1. The state of the economy. When the economy strengthens, capacities are continuously built up due to increased consumption and increased confidence in the future. After a while, the available labor force decreases, and finally, price levels also start to strengthen due to shrinking and more expensive production factors. This eventually results in price increases.
  2. Changes in production factors: In the 80s and 90s, more and more companies relocated production and manufacturing to countries with lower wages. This improved profitability, and pricing issues were not as important. Similar trends unfold in raw materials from time to time, affecting inflationary effects resulting from cost pressures.
  3. Monetary policy. Through monetary conditions, central banks adapt to global and local conditions and partly shape them. They generally operate along countercyclical aspects, trying to cool overheating economies with interest rate hikes and stimulate them with interest rate cuts during crises.
  4. Technological development: It is a general truth that, due to technological advances, the same technology becomes cheaper year by year. The development of phones is often cited as an example, while today's smartphones can do many things, in the 90s a dozen devices would have been needed for similar opportunities, which would have been several times more expensive in terms of wages.

So, economic decision-makers do not have an easy task, in addition to the above, they have to pay attention to many other factors when preparing inflation forecasts or trying to respond and influence processes through regulation. It is a generally accepted view that modern economies need minimal inflation for efficient operation, which is partly due to economic growth.

There is no general truth; advanced economies typically aim for around 2 or 3 percent inflation, while developing, growing economies slightly higher. It should be noted that zero percent or negative inflation would not be desirable, as this could damage the credit market and have unintended effects on consumption (why buy it today if it could be cheaper tomorrow?). Another negative aspect is that zero inflation typically indicates economic problems (insufficient demand), which can also have a negative impact on wages and the labor market.