When the price of groceries rises month after month without salaries keeping pace, we touch on the most concrete mechanism of monetary inflation. The widespread and lasting increase in the prices of goods and services directly reduces what each euro can buy. Understanding this phenomenon also means grasping why central banks’ decisions have very tangible repercussions on households’ daily lives and the health of businesses.
Cantillon Effect: why inflation does not affect everyone at the same time
It is often imagined that rising prices hit the entire economy simultaneously. The reality on the ground is different. When a central bank injects money into the system, the first beneficiaries are those who receive this money upstream: large banks, financial institutions, companies close to capital markets.
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These players can invest or consume before prices have started to rise. By the time the new money reaches employees, artisans, or retirees, prices have already absorbed part of this injection. This is what is known as the Cantillon effect.
In practical terms, an investment fund that borrows at low rates to acquire real estate benefits from a price that is still stable. Six months later, the same property costs more, and the individual buyer suffers the increase without having benefited from early access to liquidity. To better understand the effects of monetary inflation on the economy, it is essential to keep in mind this timing asymmetry between economic agents.
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This lag explains why, in practice, inflation deepens wealth inequalities even before it visibly impacts supermarket prices.
Savings and real interest rates: the trap of negative returns
A savings account that shows a positive nominal rate can actually lead to a loss of money. When inflation exceeds the rate paid on a fixed-income investment, the real return becomes negative. One believes they are saving, yet they are losing purchasing power.
This mechanism affects regulated savings accounts, government bonds, and most euro-denominated life insurance contracts. Savers who leave cash in a checking account experience the same erosion, amplified by the complete lack of remuneration.
How bond markets react
When inflation sets in, investors demand higher rates to compensate for the anticipated loss of value. The price of existing bonds falls, penalizing those who hold them in their portfolios. For companies seeking financing, the cost of credit increases.
A cascading effect is then observed: the rising cost of credit slows down productive investment, slows hiring, and compresses household consumption. Returns vary on this point depending on the sectors, but the underlying mechanics remain the same.
Balancing the fight against inflation and preserving growth
This is the most concrete dilemma faced by central banks. Raising key interest rates to curb rising prices comes with a cost: slowing economic activity, sometimes to the point of causing a recession.
- An increase in rates raises the cost of mortgage and business loans, which reduces demand and puts pressure on prices, but also slows down companies’ investment projects.
- Maintaining low rates supports growth and employment in the short term, but risks allowing inflation to become entrenched in economic agents’ expectations.
- The transmission of monetary policy is neither immediate nor uniform: several months can pass between a rate decision and its visible effect on prices. Investment often slows down before disinflation materializes.
This time lag forces central banks to act based on forecasts, not real-time data. A too-rapid tightening can disrupt economic momentum. A too-timid tightening allows price increases to sustain themselves through expectations.
Persistent inflation and low growth: a real coexistence
Contrary to the theoretical model where rising prices accompany an overheating economy, inflation and low growth can coexist for several quarters. Purchasing power is compressed, credit dynamics slow down, and households postpone non-essential purchases.
For businesses, the situation translates into dual pressure: rising production costs (raw materials, energy, partially indexed wages) and stagnant demand. Margins shrink, limiting the capacity to invest or hire.
Cost-push, demand-pull, imported inflation: identifying the source to adapt the response
Not all inflations are treated the same way in practice. Identifying the dominant source changes the response to be provided.
- Cost-push inflation: the rise in prices of raw materials or energy impacts production costs, then final prices. A restrictive monetary policy alone is not sufficient if the shock comes from supply.
- Demand-pull inflation: excess demand against limited supply pushes prices up. Raising interest rates is then the most direct tool to cool consumption.
- Imported inflation: the sustained depreciation of a currency raises the cost of all products purchased abroad. In the eurozone, this channel particularly impacts energy and imported manufactured goods.
In practice, these three mechanisms combine. A spike in oil prices (cost) can trigger expectations of rising prices (demand) and weigh on the exchange rate (imported). The response from central banks must then balance action on rates, communication on expectations, and coordination with fiscal policy.
Direct monetary financing of public spending, sometimes referred to as resorting to the printing press, constitutes a fourth factor of inflation. The European treaty precisely prohibits it because its effects on price stability are the most difficult to reverse once initiated.
Understanding where inflation comes from in a given situation allows anticipating which expense items will be affected first and which management or investment decisions need to be adjusted. The mechanics remain the same: every euro created without productive backing ultimately dilutes the value of all others.