In economics, there are conventional theories about inflation. While these often dominate discussions on inflation, some these theories become paradoxes when applied to special cases where their assumptions do not apply.
Below are three examples of paradoxes of inflation:
Increasing Interest Rate to address Supply-driven Inflation
Theory: Inflation is caused by excess demand. Solution is to increase interest rate to dampen demand.
Paradox: Prices barely respond despite successive rate hikes. Inflation falls and stabilizes after a year because of base effects, but CPI remains elevated.
Interest impact on inflation lags with hikes, but keeps pace if they are cuts
Theory: It takes several months for interest rate hikes to take full effect. This is the usual explanation given when inflation remains elevated despite rate hikes.
Paradox: Central Banks keep raising interest rates even if inflation is already showing signs of peaking or reversing. Monetary authorities forget the impact lag when near the inflation inflection point. This leads to overshooting.
Core Inflation expected to keep pace with Headline Inflation
Theory: Core inflation is a measure designed to exclude volatile components of inflation. Analysts cite the higher core inflation lagging behind the falling headline inflation as basis for continued concern.
Paradox: Core inflation will certainly and mathematically lag headline inflation in both ups and downs because of the removal of volatile components. Even if core inflation remains elevated, they can be offset by the higher-weighted, falling food and fuel components of headline inflation.
