What are the 5 causes of inflation?

Governments and central banks around the world are struggling to curb high inflation. In this article, we look at what inflation is, what the five main causes of inflation are and how to invest when inflation is high.

In many countries recently, the inflation rate has reached heights not seen for 40 years. 

Inflation rates measure how much prices go up or down over the previous 12 months. Rapidly rising prices generally have a negative effect across all sectors of society and the economy.

In this article, we explain the five major causes of inflation. Then, we cover why many consider silver and gold investing as a safe haven when inflation is high.

What are the major causes of inflation? 

Many analysts believe that the lifting of pandemic restrictions caused the current bout of high inflation. 

Supply chains couldn’t keep up with a sudden and intense surge of demand for products after lockdowns ended. Geopolitical conflict and the energy crisis further compounded the situation. But how exactly does inflation happen?

Here are the five main causes:

Demand-pull inflation

When incomes are growing and unemployment is low, the economy is working well. This benign situation can lead, however, to demand-pull inflation.

This is because people feel more confident about money and the security of their jobs. As a result, they spend more on goods and services. Employers make good profits so they can afford to give their staff decent wage raises. 

Over time, the amount of money in the economy grows.

This increase in the money supply can lead to too much money chasing too few goods. Manufacturers just can’t keep up with the demand from consumers and other businesses. Increased government spending can have an impact as well.

When this happens, businesses can increase their prices and be reasonably confident that people will still want to buy from them. This is demand-pull inflation.

Cost-push inflation

Part of the reason we’re suffering from higher prices at the moment is cost-push inflation.

This happens when production costs go up. These costs can include wages, raw materials and other expenses that relate to production and fulfilment.

When input costs like these rise, this pushes feed through the system meaning consumers and businesses pay a higher price for their goods and services. Employees then pressure their bosses to give them bigger wage increases to compensate for the higher prices in the shops.

This creates a cycle. As wages and raw material costs continue to climb, businesses must put up their prices to maintain their profit margin. 

When businesses charge more for their products, suppliers take this as a further cue to raise their prices to make more money. As prices climb ever higher, both employment and raw material costs increase too, perpetuating the cycle.

Inflation can spike even higher if economic or societal shocks affect supply chains and raw material shortages. Prime examples of these are pandemics, war, natural disasters, and political upheaval.

Other times, the effect of cost-push inflation is far less dramatic and temporary. Events like labour shortages, high energy costs or tax rises can cause short-term inflationary spikes.

Increased money supply (i.e. money printing)

The operations of private and central banks effectively create the money we use. Central and private banks have the authority to manage and influence the money supply within an economy, while private banks do this via the lending process.

Increased money supply, or «money printing», decreases the value of a currency because it reduces its “purchasing power”. Less purchasing power means the same amount of money doesn’t buy you as much as it used to.

In the worst-case scenario, it can lead to hyperinflation, as seen in the recent past in Zimbabwe for example.

Currency devaluation

When a currency’s value falls, it becomes cheaper in comparison to other currencies. For example, if the U.S. dollar weakens, you can now buy more dollars with the same amount of sterling than before.

On most occasions, the market drives changes in the value of a currency. Sometimes, governments choose to devalue their currency for political and economic reasons.

A lower exchange rate makes a country’s products or services cheaper for international buyers. Export booms often follow currency devaluations for this reason. 

Devaluations often lead companies to import goods instead of buying them locally. That’s because the weaker currency makes foreign goods and materials less expensive for them to buy.

It’s a perfect circle for these local companies – cheaper input costs, cheaper prices for foreign buyers and high-profit margins.

It’s not all good news, though, and it never lasts.

The companies that benefit from a surge in exports only do so because of the devaluation. This is a golden opportunity for them to make money fast. Entrepreneurs often focus on this to the detriment of focusing on improving their businesses over the long term. When the boom is over, they’re not any more competitive than they were before.

Devaluation-related export booms are temporary and usually come to an end for one of two reasons. First, the currency rises in value meaning that exports from that country become more expensive again for overseas buyers. 

Second, other countries with even weaker currencies devalue theirs so they can have their own export boom. Overseas buyers then purchase from companies in those countries instead.

For people in a country with a devalued currency, life can get hard. The cost of imported goods usually increases, so their money won’t go as far as before. Currency devaluations often result in suppressed wage increases too, leaving ordinary citizens worse off.

There are other causes of currency devaluation. Important factors include political instability, fluctuating interest rates between countries and money printing.

Government policies and regulations

Governments, like the UK’s, often aim for a 2% inflation rate. Economists believe inflation at this level is good for balancing economic growth and keeping prices stable.

Taxes play a major role in inflation. When the government raises taxes on purchases, businesses often pass these extra costs onto end users. This is an example of cost-pull inflation.

Tax breaks have the opposite effect. When governments reduce taxes, people usually spend more. However, if that causes demand to outstrip supply, prices go up. This is an example of demand-pull inflation.

Sometimes governments attempt to control the costs of essentials like rent or fuel to protect people from inflation. However, this sometimes has the opposite effect and causes shortages. 

Governments can introduce policies to manage inflation but this often causes additional problems.

Investing During Inflation

To protect the value of your investments against inflation, you could consider creating a balanced portfolio that can withstand rising consumer prices and unexpected macroeconomic events. This could be a stock market wobble, a recession, or a crash in the housing market.

While investing in assets that perform well when inflation is high makes sense, many analysts advise that risk is spread more widely.  

Commercial property with its inflation-linked contracts traditionally weathers inflationary storms well. Now that so many people work from home, offices may no longer be a good option though.

Facebook recently paid $181m to break a lease for floor space they hadn’t even moved into yet. Warehousing is booming so this may be a better option for commercial property investment.

Silver and gold investment is popular during inflationary periods. They, like commodities, have a finite supply meaning they hold their value better. History shows that the price of gold often rises during inflationary times. Gold is, in addition, a great hedge against inflation because of the demand for the metal from the manufacturing and jewellery sectors.

Many gold investors also agree that silver is a good investment. Silver investors point to its lower price point and its wide industrial uses as key advantages. Silver has many industrial applications and is key when manufacturing solar panels and electric vehicles. 

Many investors purchase silver as bullion or they buy shares in silver mining companies to benefit from an income stream.

Kinesis’ gold KAU and silver KAG digital assets offer an alternative to traditional gold and silver investment. Backed by 1:1 by physical gold and silver, respectively, these assets added another layer to this potential investment. Investors benefit from the metals’ ability to hold value, in addition to earning a monthly yield – something you don’t get with a standard physical gold or silver investment.

According to market analyst Rupert Rowling, investing in silver has a bright outlook when considering its fundamental use case: 

“Silver’s outlook is bright thanks to its use in key growth industries such as technology, solar energy, and electric cars. Manufacturers have tried to reduce the use of silver but there are only so many savings they can make.”

Regardless of the specific path chosen, it’s important to stay informed about the evolving economic landscape shaped by inflation. Inflationary times require investors to reassess the potential diversity of their portfolios and contemplate the need for assets that not only preserve wealth but provide the opportunity for appreciation during this time.

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Rupert is a Market Analyst for Kinesis Money, responsible for updating the community with insights and analysis on the gold and silver markets. He brings with him a breadth of experience in writing about energy and commodities having worked as an oil markets reporter and then precious metals reporter during the seven years he worked at Bloomberg News. 

As well as market analysis, Rupert writes longer-form thought leadership pieces on topics ranging from carbon markets, the growth of renewable energy and the challenges of avoiding greenwash while investing sustainably.

This publication is for informational purposes only and is not intended to be a solicitation, offering or recommendation of any security, commodity, derivative, investment management service or advisory service and is not commodity trading advice. This publication does not intend to provide investment, tax or legal advice on either a general or specific basis.