A law student's guide to inflation
Inflation is one of those words that we hear in the news all too frequently. If nothing else, you’ve probably complained about the rising prices of beer at Wetherspoons. A simple way to define inflation is ‘as prices rise, your money becomes less valuable’. It doesn’t seem like this has a huge impact on your life if your pint rises by a few pence a year, but over a long period of time the effect of even low rates of inflation can be huge. In the UK, £10 from 1967 had the equivalent purchasing power of £171.11 in today’s money, so the value of money has fallen dramatically in the last 50 years. There are several different causes of inflation, and these can be put into two broad categories: Demand-pull and Cost-push.
Demand-pull inflation occurs where demand for something outstrips the capacity to produce it; marketing can often play a large role here. One of the most common reasons we see inflation rise is where the economy is strong or growing, when people are feeling confident in the economy, they spend more, so demand rises and prices do to keep up. This effect is increased where people are expecting high inflation to keep rising. If you know your favourite beer is only going to get more expensive, it makes sense to stock up. When lots of people do this, it can have a huge impact of prices. The government’s policy will also play a role in creating demand-pull inflation. Over-expansion of money supply sounds like a scary phrase, but all it means is that the government is ‘printing’ too much money, so everyone has loads. In the UK, this is done through a process of quantative easing, which was used frequently to try and stimulate spending during the recession. A government that has poor monetary policy in this way, may well fall prey to hyperinflation. For example, in Zimbabwe inflation reached an estimated 80billion percent, before switching to foreign currency. Government's can also influence this type of inflation through their fiscal policy (policies around spending and taxation), usually this will be through tax cuts which allow increased spending for many.
Cost-push inflation can happen even in a recession. It’s where prices rise for any reason other than demand. Sometimes this can be due to supply issues or shortages, inflation driven by rising prices of oil is often a large part of this. Manufactured goods which have been imported or rare components are especially vulnerable to prices rising because of this. As prices rise, consumers still want the same standard of living, and so demand increased wages. This so-called wage-price spiral effect becomes more pronounced if consumers expect inflation to continue to rise. Additionally, in the same way that lower income taxes can increase demand-pull inflation, taxes on goods can contribute to cost-push inflation.
The current rate of inflation in the UK is currently 2.3%. This is measured with the Consumer Price Index, to calculate this a basket of goods and services the average person may buy is valued each month and the change measured. Over 700 different goods are included in this basket, and each category is weighted to reflect the impact a price rise in each category will have on households.
Figure 1 Annual inflation rates (Source: ONS)
The graph above shows annual measures of inflation. We can see that some of the peaks and troughs coincide with key political events, such as the Brexit referendum in 2016. CPI is a great quick measure of inflation, and using such a broad index is advantageous because it gives an overview. If we only looked at the price of beer, it wouldn’t give a good market overview. Alternatives do exist, including the Retail Price Index, which uses a different weighting and basket of goods to the CPI. My personal favourite measure is the ’12 days of Christmas index’ which calculates how the prices of gifts from the 12 days of Christmas change. For example, last year the cost of a partridge in a pear tree dropped 2.3%, but the index overall rose by 0.7%.
What is the impact of inflation?
When inflation is around 2%, it’s close to the UKs target of 2%, so it won’t have a huge impact on your life. However, if it continues to rise at a fast pace, households may have trouble affording basic goods. Currently in the UK there is concern over the rising prices of food. Aside from rising prices, inflation can hit the economy in other ways making it less efficient. High rates of inflation give rise to ‘shoe leather costs’; this means that when prices are very high more people will devote time and resources into looking for cheaper prices. An example of this is where people drive a few extra miles to a petrol station with ever so slightly cheaper prices. The other side of this is that businesses may be wasting resources on ‘menu printing costs’, if prices are rising fast businesses need to keep up. We’ve all noticed how Wetherspoon’s has been printing new menus more frequently lately, on a small-scale menus are cheap, but over the whole economy this inefficiency adds up.
We’ve mentioned how monetary policy and inflation are linked already, but inflation will directly impact the interest rate you pay on borrowed money, or are paid on your savings. Because it’s important inflation is controlled to an extent, the Bank of England will raise or lower interest rates to affect consumer spending. As inflation rises, the bank will raise interest rates to make saving more attractive. Conversely, when consumer confidence and growth in the economy is low, rates will be kept low, to make spending more attractive. Therefore, post-recession rates have been kept at historic lows, this is great for those with mortgages, but not savers. It’s also worth remembering that if the rate of inflation is higher than the interest rate you are being paid on your savings, you will be losing money the longer it’s in the bank. Because of this relationship to monetary policy, the rate of inflation is a good ‘market barometer’, a strong economy tends to have moderately high levels of inflation.
How does inflation impact businesses and law firms?
We’ve talked a lot about how inflation may affect the average person, but it can also have huge impacts on businesses, including law firms. One of the key problems international firms will face is that inflation will greatly affect the cost of multi-jurisdictional cases, as wage expectations will differ in each country depending on the current rates of inflation. This might be a large factor on where firms choose to open new offices, or outsource business to.
Larger commercial firms will be hardest hit by high inflation. Higher inflation can cause greater uncertainty in the markets leading to fewer mergers and acquisitions, as well as fewer commercial real estate transactions, and large investments in research and development. However, an area of law that may see an upturn where there is high inflation is insolvency proceedings, as smaller to medium sized businesses often struggle with rising costs.