Understanding What Inflation Actually Means

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Inflation basically means price increases.  Its opposite is deflation.  Price is essentially a reflection of supply and demand.  It can be interesting to take a close look at inflation to see what it suggests about the state of the economy.  With that in mind, here are some key points about inflation heading in the UK heading into the third quarter of the year.

There’s a difference between macro-trends and micro-trends

Macro-trends are essentially broad trends such as house prices throughout the UK.  Micro-trends are niche trends, such as house prices in a particular local area.  Macro-trends may be comprised of numerous micro-trends.  That does not, however, mean that all micro-trends will be in line with the overall macro trend.

For example, since July 2020 the overall trend in UK house prices has been very strongly upwards.  This has not, however, meant that there was equal growth across all of the UK’s local housing markets.

Demand reflects necessity and/or desirability + affordability

A buyer has to have a reason to buy a product or service.  Essentially, they have to need it or just want it.  They also have to be able to afford it.  Needs, by definition, have to be prioritized over wants.  This means that price increases for necessities reduce the amount of income people have to spend on desirable items.

Affordability reflects the price of a product or service as compared to a potential buyer’s financial standing.  The price of a product or service has to reflect the cost of producing the item or delivering the service.  It may also reflect the level of competition there is for the item.

For example, if demand for an item is high, sellers can choose to increase their prices to boost their profits.  If, however, it’s low, sellers may choose to decrease their prices to stimulate demand.  Alternatively, they may just stop selling the item.  This would reduce the supply and might benefit anyone who still keeps the item in stock.

Property sellers cannot usually just discontinue a property (especially not if it’s a flat).  They can, however, withdraw it from the market.  At least they can in theory.  Whether or not they can do so in practice will depend on their own financial standing.

Context is everything

In order to understand what inflation means, you need to know what timeframe it covers.  There are two reasons for this.  Firstly, the significance of a rise can only be understood if you know how long it took to be achieved.  For example, a 20% rise over a year is a much steeper rate of increase than a 20% rise over a decade or a century.

Secondly, knowing the timeframe a rise covers allows you to look at the prevailing economic conditions (at both macro and micro levels).  For example, in March 2020, the UK went into lockdown.  Since then, it’s been working under restricted conditions.  It’s still not fully operational.

This means that any rises to inflation have to be seen in the light of the depressed economic conditions over the past year or so.  In other words, for practical purposes, they are not new gains, they are the result of the economy regaining old ground.

The Brexit factor

Once the pandemic is fully brought under control, it will hopefully become easier to see the extent, if any, to which Brexit will impact the UK’s economy.  In particular, it will become easier to see if its impact is inflationary or deflationary.

It could be inflationary due to the increased administration now involved in trading with the EU (and NI).  It could also be deflationary due to the UK’s ability to negotiate its own trade deals.  Alternatively, it could end up being a net inflationary neutral.

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