Inflation is a sustained rise in the overall level of goods and service prices in the economy. The opposite process, when the overall level of prices decreases, is called deflation.
Consumer price index as an inflation indicator
Price movements in the economy are reflected by various price indicators, including producer price indices, the gross domestic product deflator, and the consumer price index. Inflation is generally associated with the consumer price index (CPI), which measures how prices for a set of food products, non-food goods and services consumed by an average household (i.e. the cost of the consumer basket) change over time. The CPI has been selected as the key inflation indicator because it plays an important role in measuring changes in the cost of living. In addition, the CPI has a range of characteristics making it convenient for common use, namely a simple and clear method of construction, a monthly frequency of calculation, and timely publication.
The CPI may be calculated for different periods. Consumer price levels are most often compared month-over-month, year-over-year, and versus December of the previous year.
The Federal State Statistics Service is in charge of the statistical monitoring of prices, the corresponding calculations, and the publication of data on the CPI in Russia.
Consumer basket specifics in Russia
The specific feature of the consumer basket in Russia, as generally across emerging market economies, is a relatively large share of food products (36.5% in 2014). Food prices are rather volatile. Inflation in the food market is largely affected by changes in supply, first and foremost by the harvest of agricultural crops in Russia and abroad, which significantly depends on weather conditions. Since the proportion of food products in the consumer basket is high, fluctuations of food prices may materially impact inflation in general.
In addition, the Russian consumer basket used to calculate the CPI comprises goods and services with regulated prices and tariffs. Thus, the government regulates tariffs for a range of utility services, passenger transportation services, communication services, and some others. Furthermore, prices for tobacco products and alcoholic beverages considerably depend on excise rates.
Both domestic and imported goods and services satisfy consumer demand. There are no statistics on the proportion of imports in the CPI. However, the percentage of imports in the structure of retail trade commodity resources (approximately 44% in recent years) may give an understanding of this proportion in terms of goods. The sizeable share of imported goods in the consumer basket is the reason why changes in the ruble exchange rate substantially impact inflation.
Prices may grow more quickly or slowly, which is a rise or decline in inflation, respectively. In addition, there may be various reasons causing inflation movements. Let us consider them in the context of price growth acceleration. If demand for goods and services exceeds supply, this involves the proinflationary effect of demand-side factors. In some cases, demand may demonstrate a faster-than-expected rise, driven by excessively affordable loans and accelerated growth of economic agents’ nominal income. These sources of excess demand are called ‘monetary factors of inflation’, which imply pressure on prices caused by an excess of money.
Inflation may also increase when an imbalance in the market for a particular product or service arises because of insufficient supply, e.g., a poor harvest, export restrictions or a monopolist’s actions.
In addition, inflation may be driven by a rise in unit production and sales costs due to growth of prices for raw materials, components, higher payroll expenses, taxes, interest payments, or other expenditure. An increase in costs may also entail a reduction in output and, consequently, the emergence of additional proinflationary pressure because of insufficient supply.
Growth of prices for imported components of costs may be associated with both a rise in world prices and depreciation of the national currency. Moreover, weakening of the national currency may directly affect prices for imported end products. The overall impact of exchange rate movements on price changes is called the ‘pass-through’ and is often analysed as an independent inflation factor.
Economic theory distinguishes inflation expectations as a special factor—these are economic agents’ assumptions regarding future inflation. Manufacturers take into account expected inflation levels when making decisions on prices for their own products, salaries, output and investment. Households’ inflation expectations impact their decisions on amounts of available funds to be saved or spent. Economic agents’ decisions influence the demand for and supply of goods and services, and ultimately, inflation.
Adverse consequences of high inflation
High inflation diminishes the purchasing power of income of all economic agents, which negatively affects demand, economic growth, living standards, and public sentiment. When income declines in value, this limits possibilities and discourages savings, hindering the creation of a stable financial environment for investment. In addition, high inflation may also be pushed by increased uncertainty, complicating decision-making by economic agents. All the above adversely impact savings, consumption, output, investment, and generally, the conditions needed for sustainable economic development.
Benefits of price stability
Price stability implies that the growth rates of consumer prices remain low and, therefore, are not taken into account by economic agents in decision-making. When inflation stays low and predictable, households tend to save money in the national currency for long periods without worries, being confident that their deposits will not decrease in value due to inflation. In turn, long-term savings are a source of funds for investment. When prices are stable, banks are ready to extend long-term loans to borrowers at relatively low interest rates. Therefore, price stability creates an environment for investment growth and, ultimately, for sustainable economic development.