What is cost inflation?

Cost inflation happens when stuff gets more expensive to make. Maybe the ingredients to make something – like the sugar and flour to bake cookies – suddenly cost a lot more money than they used to. Or maybe the workers who make the stuff need to get paid more, so the company has to raise their wages. When these “inputs” (the stuff that goes into making other stuff) get pricier, companies have to charge more money for the things they sell. That’s cost inflation.

Why does cost inflation matter?

Cost inflation makes life harder for everyone. When companies have to pay more to make things, they charge us more money to buy those things. Suddenly, our money doesn’t go as far as it used to. We can’t afford to buy as much stuff, or we have to spend more to get the same amount of stuff we used to.

Workers feel it too. As prices go up, the money they make doesn’t stretch as far. They have trouble paying for rent, food, clothes, all that important stuff. So workers will often ask for raises when cost inflation happens. They need more money just to keep up with higher prices.

The cost inflation loop

Here’s the tricky part. When workers get paid more, that’s another “input” cost for companies. Remember, wages are one of those things that can cause cost inflation in the first place. So if workers get raises, companies might have to raise their prices AGAIN to afford those higher wages.

Then we’re right back where we started. Prices are even higher, so workers need even bigger raises. Companies give raises, then raise prices more. It can turn into a nasty cycle, with prices and wages chasing each other up and up.

Causes of cost inflation

Lots of things can trigger this whole process. Let’s break down some of the big ones:

Rising raw material prices

Imagine you run a bakery. You need flour, sugar, butter, all that good stuff to make your tasty treats. If there’s a shortage of wheat one year and flour prices shoot way up, your costs just jumped big time. You’re probably going to have to charge more for your croissants and cupcakes to make up for it. Multiply this across the whole economy and you’ve got cost inflation.

Higher wages

Workers are another big “ingredient” for most companies. And just like with flour or sugar, if wages go up, so do costs for businesses. Maybe there’s a shortage of qualified workers in a certain field, so companies have to offer big salaries to hire the people they need. Or maybe the government raises the minimum wage. Great news for workers, but it means higher costs for companies – which can lead to cost inflation.

Taxes and regulations

Governments can accidentally trigger cost inflation too. Let’s say they put a new tax on gasoline. That makes it more expensive for trucking companies to operate, which means they charge more to transport goods. Those higher transportation costs get passed on to stores, who then pass them on to us in the form of higher prices. Regulations can have a similar effect – if the government makes companies follow new rules that are expensive to comply with, those costs often end up getting priced into goods and services.

Exchange rates

In our global economy, exchange rates (the value of different countries’ money compared to each other) can cause cost inflation too. Imagine a US car company that buys parts from Japan. If the value of the Japanese yen goes way up compared to the US dollar, suddenly those car parts are a lot more expensive. The car company has to raise prices to make up for it. That’s cost inflation sparked by exchange rates.

Effects of cost inflation

When cost inflation strikes, it can cause some real economic damage:

Lower “real” wages

Usually, wages don’t go up as fast as prices during cost inflation. Which means even if you’re making the same amount of money, it doesn’t go as far. Economists call this a decrease in “real wages” – how much actual stuff your paycheck can buy. It’s a sneaky pay cut that cost inflation causes for most workers.

Lower consumer spending

When prices go up and our money doesn’t go as far, we tend to spend less. We cut back on extras, put off big purchases, eat out less, take fewer vacations. This drop in consumer spending can be bad news for the whole economy. When we buy less stuff, companies make less money. They might have to lay off workers or even go out of business. Cost inflation can be a real drag on economic growth.

“Sticky” prices

One weird thing about cost inflation is that it can be hard to undo. Companies are usually pretty quick to raise prices when their costs go up. But they’re a lot slower to lower prices when costs go down. Economists call this “price stickiness.” It means even after the initial trigger for cost inflation goes away (like if the price of flour goes back down for our bakery example), prices might stay high for a while. That prolongs the pain of cost inflation.

Real-world examples of cost inflation

Cost inflation isn’t just some academic theory. We’ve seen it happen in the real world plenty of times. A few examples:

1970s oil shocks

In the 1970s, the price of oil shot way up. Gasoline got super expensive, which drove up transportation costs for companies. It also made it pricier to run machines in factories, heat office buildings, all kinds of stuff. This big jump in a crucial “input” caused major cost inflation throughout the world economy.

Venezuela’s hyperinflation

In recent years, Venezuela has been hit by some of the worst cost inflation ever. The government printed way too much money, which made the value of Venezuela’s currency plummet. That jacked up the price of imported goods, since Venezuelan money suddenly wasn’t worth much on the global market. At the same time, years of government overspending led to huge budget deficits. The government tried to close the gap by printing even more money. It turned into a vicious cycle of cost inflation, with prices skyrocketing by hundreds or even thousands of percent per year. A real disaster.

Post-COVID supply chain snarls

The COVID-19 pandemic caused all kinds of cost inflation. Factories around the world shut down for a while, leading to shortages of many goods. Shipping got snarled up too. Suddenly, all kinds of “inputs” were in short supply and more expensive. At the same time, governments pumped a bunch of money into the economy to help people get through the crisis. That put more money in people’s pockets, which drove up demand for goods and services at the exact moment when supply was lower. The result? You guessed it, cost inflation. Prices in 2021 and 2022 jumped by the highest amounts in decades in many countries.

Wrapping it up

Cost inflation is a sneaky but serious economic problem. It happens when the “ingredients” companies need to make stuff – whether it’s raw materials, worker wages, taxes, or whatever – get more expensive. That drives up the prices of the actual finished goods and services we all buy. Which leaves most of us worse off, since our money doesn’t go as far. Cost inflation can be caused by lots of things, from commodity shortages to minimum wage hikes to exchange rate swings. And once it gets going, cost inflation can be tough to stop. Prices and wages start chasing each other up in a vicious cycle. Policymakers have to be really careful to keep cost inflation under control, or it can do some real damage to the economy. Basically, cost inflation is just one more reminder of how interconnected this whole economy thing is – and how tricky it can be to keep it all running smoothly.