Last week, we talked about the impact of inflation on bonds, but how is inflation explained? How does it influence the monetary policies of central banks? Here are a few explanations.

What generates inflation?

Inflation is the rising cost of products and services. It can have several sources. Generally speaking, it's the law of supply and demand that generates it. In effect, this rule, which applies to most goods and services sold, will increase the value of an object of interest to many potential buyers. Before globalization, these phenomena occurred mainly within individual nations, but since the opening up of economic markets, they have become a worldwide phenomenon. The rising standard of living of some populations in emerging countries is accentuating the pressure on services and products, generating inflation. Most of the time, this demand-driven inflation is low and healthy, as it is favorable to economic growth.

On the other hand, there is cost inflation, which is linked to raw material prices. This type of inflation is not necessarily linked to growth, since it is sometimes the consequence of decisions or events, and is more sudden and difficult to control. This is the kind of inflation we've been experiencing since COVID and the war in Ukraine. Numerous markets and world trade have been impacted, and a sharp rise in the price of certain raw materials, including energy, has created an inflationary wave that is affecting the whole world.

A look back at the different periods of inflation

In the aftermath of the Second World War, a major period of reconstruction and rising demographics led to strong growth and galloping inflation of around 50% for several years, before dropping to 10-15% and stabilizing at between 2 and 7%. The first oil crisis and the end of the convertibility of the dollar put an end to this period of thirty glorious years. This event caused the price of oil to soar, multiplying by a factor of 4, and with it inflation!

After a failed stimulus policy during the first two years of François Mitterrand's presidency, the "Tournant de la rigueur" (austerity turn) took shape in 1983, triggering a sharp drop in inflation, which was contained between 2 and 5% until the 1990s, before stabilizing for the long term at around 1 to 2%.

What is the impact of monetary policy?

Each central bank's monetary policy is designed to keep inflation and the value of money under control. Since the launch of the euro in the early 2000s, the monetary policy that concerns us in France has been that of the European Central Bank (ECB). Its objective is to achieve inflation of around 2%, so that all economic players have some visibility. But why and how do monetary policies affect inflation?

To increase inflation, the "printing money" method was often used. Today, the Central Bank acts on its key rates upwards and downwards to influence inflation. Ultimately, this is all down to the law of supply and demand. When key rates are low, banks lend money at low rates, and more lenders are likely to borrow. This increases the amount of money in circulation, and the large number of buyers/investors pushes up prices as the number of offers remains relatively constant, generating inflation. Conversely, when inflation is high, including when linked to rising commodity prices, the strategy is to raise key interest rates! By decreasing the quantity of money and limiting the number of transactions, the various economic sectors are loosened up, thereby reducing inflation.

All these policies are reviewed on a regular basis, and have to adapt to multiple factors. It is important to have a global vision to make the right choices, limit risks and anticipate. Wealth A7's wealth management advisors are here to support you and keep you informed - contact us!

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