What Is Inflation and Why Does It Happen?

Learn what inflation is, its main causes, how interest rates influence it, and its impact on the economy in 2025

Inflation can have devastating effects on a country’s economy. If not properly controlled, it can hinder economic growth and jeopardize the well-being of future generations. In today’s context, inflation is highly volatile, with potential shifts in either direction. In 2024, Spain recorded an inflation rate of 2.8%, directly impacting the purchasing power of millions of households. In 2025, the debate over its causes and consequences remains particularly relevant, driven by factors such as geopolitical tensions and energy price uncertainty. ⁣⁣

The war in Ukraine and the successive rise in energy and raw material prices have been cited as key triggers of the widespread price increases since 2022. Additionally, the savings accumulated and incentives deployed during the COVID-19 years have also been described as the “breeding ground” that amplified this phenomenon.

⁣⁣This article seeks to clarify the following questions: What is inflation and what causes it? What specific factors are driving inflation in 2025? These are some of the issues we will address below.

What Is Inflation? ⁣⁣

The European Central Bank (ECB) defines inflation as the general increase in prices across an economy—not just of individual goods—which results in each euro buying fewer goods and services than before. In other words, inflation erodes the purchasing power of money over time. ⁣⁣

Inflation is calculated based on the average consumption habits of a household, represented by a “shopping basket” in which each type of good and service has a different weight depending on its relevance to the household budget. The price variation of this basket determines the inflation rate. ⁣⁣

Inflation in Spain ⁣⁣

In Spain and across Europe, the CPI (Consumer Price Index) measures the price of this shopping basket; it is monitored and regulated to make informed decisions about the “temperature” of the economy. Maintaining price stability and keeping annual inflation around 2% is the ECB’s primary goal. The aim is to ensure that inflation remains low, stable, and predictable.

⁣⁣In Spain, the CPI is compiled and published monthly by the National Statistics Institute (INE). In December 2024, Spain’s CPI reached 2.8%, a rise of four tenths of a percentage point compared to the previous month. Core inflation also increased, reaching 2.6%. The main driver of this spike was the 3.5% rise in service prices. ⁣⁣

At the European level, inflation in the Eurozone was 2.4%, up two tenths from the previous month. Spain’s Harmonized Index of Consumer Prices (HICP) also stood at 2.8%, resulting in a positive spread that directly affects price competitiveness. ⁣⁣

Controlling inflation is critical to the economic health of any country or region with a shared currency, such as the European Union: persistent high inflation leads to a loss of purchasing power.

Examples of Inflation’s Impact on the Economy

⁣⁣To better understand the potential effects of uncontrolled inflation, let’s consider two well-known examples: ⁣⁣

Hyperinflation (Argentina) ⁣⁣

In 1989, Argentina entered an inflationary spiral that continues today. An imbalanced trade balance led to an unsustainable foreign debt situation. Unable to service its debt, the country experienced severe currency devaluation, with inflation reaching 3,000% that same year. Structural imbalances persist more than 30 years later: annual inflation in 2022 was 98%, and in 2024 it reached 117.8%, according to the National Institute of Statistics and Censuses (INDEC) in January 2025. ⁣⁣

Deflation (Japan) ⁣⁣

Since the mid-1980s, Japan has experienced extremely low, and at times negative, inflation. This has constrained economic growth, and monetary policies have proven ineffective in reversing the trend. Inflation remains much lower than in most Western countries: -0.2% in 2021, 4% in 2022, and 2.5% in 2024, according to Japan’s Ministry of Internal Affairs and Communications.

Methods to Control Inflation ⁣⁣

The ECB’s main tool to combat inflation is monetary policy, particularly interest rates. The theory suggests that low interest rates “heat up” the economy, while restrictive rates “cool it down,” helping to lower inflation in the medium term. ⁣⁣

During the 1970s and 1980s, many European countries, including Spain, experienced high inflation. Since the euro’s adoption and the ECB’s creation, inflation has been more stable and controlled. ⁣⁣

What Are Interest Rates? ⁣⁣

Interest rates are a central tool used by central banks to regulate the economy. The ECB sets benchmark rates that directly affect the cost of money—impacting loans, credit, and deposits. ⁣⁣

Interest rates are the cost of borrowing money over a specified period, usually expressed as a percentage of the principal. They represent the borrowing cost for debtors and the return on savings or investments for lenders. In essence, interest rates determine how expensive or profitable borrowing and lending money is. ⁣⁣

Economic logic behind interest rate policies: ⁣⁣

• Low rates: stimulate consumption, investment, and credit. May drive inflation. ⁣⁣
• High rates: make money more expensive, reduce spending, and tend to curb inflation ⁣⁣ ⁣⁣

Interest Rate Forecast for 2025

⁣⁣In 2024, the ECB adopted a cautious, data-driven approach. President Christine Lagarde repeatedly emphasized that future decisions would depend on inflation trends, wage growth, and economic forecasts.

⁣⁣With inflation gradually decreasing, several financial analysts—including reports from the IMF, Bloomberg, and the Financial Times—suggest that the ECB may begin a path of gradual rate cuts throughout 2025. Current forecasts suggest:

• ⁣⁣First rate cut in Q2 2025, if inflation remains stable below 2.5%.
• ⁣⁣Cumulative reduction of 50–75 basis points during the year, depending on growth trends and the global environment. ⁣⁣

Nevertheless, the ECB is expected to proceed with caution. The war in Ukraine, geopolitical tensions in the Middle East, and oil price volatility remain sources of uncertainty that could disrupt any forecasts.

Causes of Current Inflation ⁣⁣

The global economic context is complex, and attributing the price surge to a single factor would be simplistic. Although the war in Ukraine has been a major trigger—with sanctions on Russia and supply chain disruptions causing shortages and price hikes—other key factors must be considered:

Over a Decade of Expansionary Policy

⁣⁣Since 2010, both the ECB and the Federal Reserve have kept interest rates near zero, or even negative in Europe. During the pandemic, the Fed injected over $6 trillion in stimulus and direct aid. In Europe, the Spanish Treasury issued €130 billion in public debt, almost entirely purchased by the ECB as part of a €1.85 trillion stimulus plan. This decade of “printing money” has contributed to current inflation. ⁣⁣

COVID-19’s Impact on Supply Chains ⁣⁣

The pandemic caused severe disruptions to global supply chains, reducing the availability of essential products and fueling price increases. ⁣⁣

Robust Demand ⁣⁣

A healthy job market and pandemic-era savings have led to exceptionally strong demand. For example, the U.S. recorded a 3.5% unemployment rate—effectively full employment.

⁣⁣This complexity is evident in events such as the banking crisis triggered by rapid rate hikes, which led to the collapse of Silicon Valley Bank in the U.S. and the forced takeover of Credit Suisse by UBS in Europe.

Protect Your Wealth from Inflation Through Real Estate Investment ⁣

Asset Performance (1980–2024) ⁣⁣

Over the past four decades, key financial assets have followed very different paths. Equities have historically delivered the highest returns, particularly during sustained economic growth. Bonds have offered more stable, conservative returns, aligned with interest rate cycles. ⁣⁣

Gold, a traditional safe haven during times of uncertainty, has experienced stagnant phases punctuated by growth surges linked to geopolitical tensions and inflation. Meanwhile, real estate has shown steady long-term growth, bolstered during crises by its perceived safety and tangibility. ⁣⁣

Real Estate Investment Funds: A Solid Option During Inflationary Periods ⁣⁣

Real Estate Investment Trusts (REITs) offer investors access to the property market without having to purchase real estate directly. These vehicles invest in income-generating assets—such as residential buildings, offices, hotels, or logistics centers—and distribute most profits as dividends. ⁣⁣

Key advantages include: ⁣⁣

• Diversification: pooling multiple properties reduces risk. ⁣⁣
• Liquidity: unlike traditional real estate, REITs are publicly traded.
• ⁣⁣Attractive income: regular dividends, even in high-inflation environments.
• ⁣⁣Inflation hedge: rental income indexed to inflation helps preserve purchasing power. ⁣⁣

Spain has faced inflationary episodes before. Prior to the ECB’s creation, annual inflation often hovered around 5%. From the late 1960s, it rose as high as 28% and didn’t drop below 5% until the 1990s. Comparing inflation trends in Spain with Europe and the U.S. shows similar trajectories, though Spain has experienced more pronounced peaks. Since joining the EU in 1986, Spain’s price trends have closely aligned with those of its Western peers. ⁣⁣

To better understand inflation’s impact and identify effective investment strategies, two analyses were conducted: ⁣⁣

1. Performance of €100 invested in various assets from 1978 to 2022: Comparing returns on stocks, gold, bonds, and residential real estate over four decades. ⁣⁣

2. Analysis of the 1986–1996 period: Examining how different assets fared during a high-inflation decade to identify effective inflation-era strategies. ⁣⁣

These studies aim to provide historical perspective to help investors make informed decisions to protect their wealth in high-inflation environments.

⁣⁣How Would €100 Have Performed Across Different Assets from 1978 to 2022?

Analyzing the performance of €100 invested in various assets from 1978 to 2022 reveals significant differences in their ability to outpace inflation: ⁣⁣

• Bonds—and especially gold—underperformed inflation for nearly two decades, from the late 1980s to the 2008 crisis. ⁣⁣
• In contrast, stock indices and real estate consistently outperformed inflation, with stock indices increasing in value by up to ten times more than inflation over the same period.

How Would €100 Have Performed Across Different Assets from 1986 to 1997?

During the analyzed high-inflation period, both German bonds and residential property consistently matched or exceeded inflation rates. Residential real estate stood out throughout the period, although a late surge in the stock market brought equity returns in line by the end of 1997.

Conclusions ⁣⁣

While it’s impossible to precisely forecast how today’s inflationary situation will evolve, it is clear we are navigating a fragile global economic landscape—especially with 2025 projections pointing to moderate yet persistent inflation. In this environment, it’s crucial to prepare for various scenarios and consider investment strategies that safeguard purchasing power. ⁣⁣

History shows that during inflationary periods, it’s better to keep wealth invested rather than idle in a bank account. Controlled-risk assets such as bonds, gold, equities, and real estate have demonstrated strong potential to offset inflation’s effects. In 2025, these assets are expected to continue providing valuable protection against currency depreciation. ⁣⁣

Real estate investment, in particular, remains one of the most resilient options during inflationary times. In 2025, real estate offers not only value appreciation but also additional advantages—chief among them the ability to finance purchases. In such scenarios, inflation has a double-positive effect: on one hand, property values tend to rise with demand; on the other, the real value of outstanding debt decreases over time, allowing investors to benefit from financial leverage.