What are the different types of inflation?

While inflation frequently makes headlines, we hear less about deflation, hyperinflation and stagflation. What do these terms mean, and how do they affect the economy? myLIFE provides some insights.

What is inflation?

First, let’s define inflation: a general and sustained increase in prices over a given period. In Luxembourg, inflation is measured using the Consumer Price Index (CPI), which estimates the average change in the value of a basket of household consumer goods between two periods.

The prices of products and services we use every day are analysed to see how they change over time. This variation gives the inflation rate for a month, a year, and so on.

As prices rise, purchasing power diminishes, as we can purchase fewer goods and services with the same amount of money than we could before. Annual inflation of 3% means that a shopping basket that cost you EUR 100 a year ago will cost you EUR 103 today. In other words, during periods of inflation, money loses value, which also negatively affects your savings.

Economists consider several factors that can trigger a general price increase:

• • Strong demand for products and services relative to the existing supply of goods: demand-pull inflation.
  • An increase in production costs for businesses (energy prices, commodities, wages, etc.): cost-push inflation.
  • Excessive money creation relative to the quantity of goods and services produced: monetary inflation.
  • A decrease in the value of a currency relative to major currencies (dollar, euro, yen), leading to higher import costs: imported inflation.

In practice, these different causes of inflation can sometimes occur simultaneously and coexist.

The ECB’s target s to maintain a moderate and steady rise in price levels with an inflation rate of 2% over the medium term.

Inflation regulated by central banks

The central banks maintain price stability. In the euro zone, the European Central Bank (ECB) is responsible for ensuring that inflation remains low, stable and predictable. “Stable prices allow money to keep its value, and they help people and businesses better plan their spending and investment. That helps the economy to grow, in turn creating jobs and prosperity.” (source: ECB).

Excessively high or low inflation could be harmful to the economy. This is why the ECB’s target is to maintain a moderate and steady rise in price levels with an inflation rate of 2% over the medium term.

To ensure price stability and regulate the level of inflation, the ECB and national central banks have a number of conventional and unconventional monetary policy instruments at their disposal. Here are a few simplified examples:

• • Key rates: key rates influence the interest rates at which commercial banks can borrow money from the ECB. Raising them makes it more expensive for financial institutions to take out loans from central banks. These increases are passed on to individuals and businesses when they borrow money, which means they consume less and save more. This weakens demand, slows economic activity and reduces (or slows down) price inflation. Conversely, lowering key rates stimulates consumption, investment and borrowing, leading to increased economic activity and, in principle, higher prices.
  • Reserve requirements: financial institutions are required to deposit part of their funds with their national central bank. By varying the level of this reserve, the ECB affects banks’ ability to lend money: the lower the rate, the more commercial banks can lend, and vice versa.
  • Asset purchases: the ECB buys and sells financial assets on the market to adjust the amount of money in circulation and influence the level of inflation.
  • Forward guidance: the ECB’s public statements about its future monetary policy direction can influence investment, consumption or borrowing decisions and, consequently, inflation.
  • Other tools include the use of negative interest rates and long-term bank refinancing operations, etc.

The use of these various tools is adapted according to inflation forecasts and the level of growth. However, it sometimes happens that price stability cannot be maintained. This leads to phenomena such as deflation, hyperinflation or stagflation. What do these terms mean?

Deflation can be caused by a financial crisis, overproduction of goods and services or high levels of debt.

Deflation

Deflation, also known as negative inflation, is the opposite of inflation. It manifests as a general and sustained decrease in prices. Deflation can be caused by a financial crisis, overproduction of goods and services or high levels of debt.

Although it might seem beneficial at first glance, this overall decline in prices is not good for the economy as individuals and businesses will be inclined to postpone their purchasing or investment decisions as they anticipate a further fall in prices. This means that overall consumption slows and production also drops correspondingly. This results in fewer job opportunities and rising unemployment, which impacts household incomes. Moreover, loans become more difficult to repay as the real value of debt increases. This is known as a deflationary spiral.

To rectify the situation, authorities can introduce measures to stimulate economic activity: interest rate cuts and asset purchases to inject liquidity and facilitate credit and consumption, government subsidies and tax incentives, etc.

Useful info: This is sometimes referred to as sectoral deflation, which is a price decrease in a particular sector, following technological progress that allows for reduced production costs or productivity gains. This affects only a few products (new technologies, for example) rather than the entire economy, as with general deflation.

Periods of deflation affected the United States and Europe in the 1930s, following the stock market crash, and Japan in the late 1990s, after the collapse of a stock market and real estate bubble. More recently, in the 2010s, the euro zone narrowly averted a phase of deflation.

N.B.: deflation should not be confused with disinflation, which refers to a decrease in the inflation rate that nevertheless remains positive: prices continue to rise, but more slowly.

Hyperinflation typically occurs in the context of economic and political crises.

Hyperinflation

Hyperinflation is an extreme case of very high inflation. The prices of goods and services rise rapidly and uncontrollably (over 50% per month on average).

It typically occurs in the context of economic and political crises, such as when a country’s budget deficit is very high and the government increases the money supply to repay its debts. More money in circulation pushes up prices, which in turn pushes up wages, which in turn pushes up prices, creating a vicious cycle known as a hyperinflationary spiral. Additionally, the increased money supply devalues the currency, raising import prices and further exacerbating inflation.

Hyperinflation has harmful repercussions on the economy: it causes money to lose its value, which impacts purchasing power and the value of savings. Expenses become difficult to predict as prices fluctuate continuously. Trust in financial institutions erodes and production collapses, leading to rising unemployment and business failures. This particular context then leads to social and political instability.

To overcome this, fiscal policy needs to be revisited and economic and even political reform considered. It may also be necessary to peg the national currency to a more stable foreign currency or even adopt a new one.

Several cases of hyperinflation have been recorded in history. One of the best-known is that of Germany after World War I, but we can also cite, more recently, Argentina, Zimbabwe and Venezuela.

Stagflation can be caused by a rise in commodity prices or by the creation of significant amounts of money.

Stagflation

Stagflation (a contraction of stagnation and inflation) refers to a prolonged period of high inflation combined with low economic growth (or no growth) and high unemployment. It can be caused by a rise in commodity prices or by the creation of significant amounts of money.

This situation is exceptional because, typically, sustained growth leads to rising prices. It is also rare for both inflation and unemployment to be high at the same time.

Such a scenario is challenging for central banks to manage. Generally, when inflation is high, they raise interest rates or increase the money supply. However, during a period of stagflation, this strategy risks undermining economic growth by limiting consumption and investment. Conversely, if central banks reduce interest rates or decrease the money supply, prices can rise, further increasing inflation. Monetary authorities and governments must combat rising prices while stimulating growth.

A period of stagflation occurred in the 1970s following the first oil shock. The sharp rise in petrol and commodity prices led to a marked increase in inflation in the US and the UK. Production costs then climbed, prompting companies to increase their prices, which led to a decrease in consumption and a sharp slowdown in economic activity.

Useful info: Stagflation should not be confused with slumpflation, which refers to high inflation combined with a decline in GDP and economic growth.

You now know a little more about inflation, deflation, hyperinflation and stagflation. These brief examples show how important it is for monetary authorities to anticipate and control price trends to ensure that the economy functions smoothly and to prevent crises.