Inflation occurs when too much money chases too few goods. Money is like any other commodity: the more there is of it, the less value it holds.
We’ve seen energy prices rise because the demand has exceeded supply as the world economy recovers from the Pandemic at the same time as the situation in Ukraine has led to the sanctioning of Russian oil production.
We can respond to the higher energy price by cutting our consumption of energy, or if that is too painful, by paying the higher price and instead, manage our limited finances by cutting our consumption of something else. Collectively, as millions of us make these decisions, there will be either a reduction in the demand for energy, or a reduction in the demand for other commodities. Prices will fluctuate accordingly: The price of energy will ease as demand for it at the higher price falls, or if we just can’t do without it, then the prices of other goods will fall as we cease to purchase them because we are now spending so much on energy instead.
This will be an uncomfortable process in an economy like ours which is so reliant on consumer expenditure. Our higher energy bills will inevitably squeeze other aspects of economic activity that we can no longer afford. There will not however, be any increase in the general level of prices. The higher price of energy will be offset by the falling prices of goods that we can no longer afford.
A general rise in prices can only be sustained if we try and avoid the pain by inflating the economy to accommodate the higher level of prices by ‘printing’ and circulating more money. We have been doing this in a number of ways for years. Understandably, governments -fearing recession and unemployment due to the banking crisis in 2008 and the pandemic more recently- increased their own spending, borrowed more, and extended credit throughout the economy.
Initially, this did not drive-up prices because demand remained suppressed. Now however, we are at full employment, there are huge world-wide supply chain problems and we have had the oil price shock. We are in a situation where too much money is chasing too few goods.
The only blunt tool the Bank of England currently has with which to remedy this, is to increase interest rates to try and squeeze some of the excess demand out of the economy. This will hurt, but it will pass.
What we must not do is feed the monster by creating more demand in the economy through reduced taxes or increasing government expenditure to ease the short-term pain. Such policies will drive prices up further and -most damaging of all- create an expectation that inflation will continue. That would lead to excessive wage demands, which would reduce employment, and -so proceeding- give rise to further demands to inflate the economy with more spending and credit to mop up that unemployment…and so the cycle will continue.
We’ve been here before: welcome to the 1970ies.
Best to grit out teeth and take the painful medicine now, than perpetuate if for decades.