Understanding inflation

Are you gradually losing your purchasing power? Here is what that broad rise in food and commodity prices portends

Inflation is an essential economic indicator. Central banks and financial markets scrutinize inflation as it heavily influences their decision-making. It also plays a pivotal role in the value of currencies. As currency markets react to inflation data, exchange rates change.

Inflation is characterized by a broad rise in the prices of goods and services across different economic sectors, eroding consumer and business purchasing power. For context, your shilling will not go as far today as last month.

To understand the effects of inflation, take a commonly consumed item and compare its price from one period with another. For example, in 2013, a packet of maize flour cost Sh80; by 2019, it had climbed to Sh140 and Sh300 in 2023. This is inflation; neither is it limited to price spikes for any single item or service; it refers to increases in prices across a sector, such as retail or automotive—and, ultimately, a country’s economy.

Inflation can have positive effects when it’s within range. For instance, it can stimulate spending and thus spur demand and productivity when the economy is slowing down and needs a boost. Conversely, when inflation begins to surpass wage growth, it can be a warning sign of a struggling economy.

Inflation affects consumers most directly, but businesses can also feel the impact. Households, or consumers, lose purchasing power when the prices of items they buy, such as food, utilities, and petrol, increase. On the other hand, companies lose purchasing power and risk seeing their margins decline when prices increase for inputs used in production, like diesel and other raw materials.

How to measure inflation

The government measures inflation by comparing the current prices of goods and services to previous prices. The Consumer Price Index (CPI) is the most widely used measure of inflation. Measuring agencies determine the current value of a “basket” of various goods and services consumed by households, referred to as a price index, by comparing the value of the index over one period to another, such as month to month, which gives a monthly rate of inflation, or year to year, which gives an annual rate of inflation.

There are two primary types, or causes, of inflation:

There are two broad, general causes of inflation. Each is also its own inflation type and requires its unique response from policymakers. The two main causes of inflation are:

Demand-pull inflation occurs in a strong economy – with increasing incomes and purchasing power, declining unemployment levels, and increased demand for goods and services. This scenario decreases the total number of goods and services available because more people can afford the limited supply of existing goods and services, which, in turn, raises prices.

Cost-push inflation is caused by an increase in the cost of goods due to causes on the supply end. For example, if the costs of raw materials rise and businesses cannot keep up the production of manufactured goods, the cost of manufactured goods goes up. Natural disasters, pandemics like Covid, and rising oil prices may all result in cost-push inflation.

How does inflation affect pricing?

When inflation occurs, companies typically pay more for input materials. One way for companies to offset losses and maintain gross margins is by raising prices for consumers. Still, if price increases are not executed thoughtfully, companies can damage customer relationships, depress sales, and hurt margins.

Done the right way, recovering the cost of inflation for a given product can strengthen relationships and overall margins.

Inflation and interest rates

Central banks – such as the Central Bank of Kenya- set interest rates. They refer to the amount you pay back on loans and how much interest banks pay on savings.

Inflation and interest rates have an inverse relationship. If interest rates are high, people get more for their money when they save in a bank. As a result, people save more and spend less. People are also less likely to take out loans as they are more expensive. This means purchases of goods like houses drop due to low-value mortgages.

If people spend less money, the demand for goods and services decreases. As such, businesses take action to entice people into spending. Usually, this means dropping prices. When prices fall, inflation goes down.

Why interest rise

The challenge for central banks is to determine the optimum time to increase and decrease interest rates to benefit the economy.

Reducing interest rates accelerates economic growth. Consumer spending increases, which boosts the economy, but inflation increases too. Central banks eventually need to raise rates to stop inflation from getting out of control. If they didn’t, prices would become too high, purchasing power would decrease, and savings would deplete.

Increasing interest rates slows economic growth. But, despite weighing on the economy, raising rates is necessary to control inflation. Central banks look to raise interest rates at a point when the economy is doing well. (