A lot of central banks across the world have adopted inflation targeting frameworks with an emphasis on price stability. Inflation being a measure of average changes in prices of goods and services in an economy means that if it’s left to spiral out of control, the purchasing power of a currency would be decreasing over time. In other words, 1 rand would buy less and less in the future.

A number of factors drive inflation in an economy –

Price expectations:
If you think that good X will be cheaper in the future, you hold back your spending and defer your purchases to a later date. Suppliers reduce prices to entice you to spend but this validates your price expectations and you hold back your spending even more. This creates a deflationary environment (general price decreases in the an economy) which leads to lower economic growth. VERY VERY DANGEROUS!

On the other side, imagine a scenario when you know that the price of good X would have increased in a year’s time. What consumers would do is buy it today to avoid paying more for it in the future. This is great because it keeps the wheels of the economy turning.

Demand side inflation:
Households and firms spend (increased demand for goods) and suppliers increase prices.

It is clear that inflation is good for an economy but can be also be devastating when left to spiral out of control. Where we now find ourselves, as South Africa and the world at large, is a place of stagflation. Inflation in the developed parts of the world has surpassed target levels with economic growth lagging far behind. The biggest driver here being supply-side shocks where consumers are demanding more goods than can be supplied, leading to upward pressure in prices and inflation.

To achieve price stability, central banks either use interest rates or money supply to manage inflation. The South African Reserve Bank uses interest rates to contain inflation within their target bank of 3 and 6 percent. When inflation threatens to the upper band, they would increase interest rates, households and firms borrow less, spend less – reducing demand for goods and services – which then leads to a reduction of prices to entice people to buy more. This reduction in prices then leads to lower inflation, achieving central bank objectives of protecting the buying power of the rand and price stability.