Inflation Update (August 2022)
George Graves provides an update on his article on inflation from the beginning of 2022.
Having ceased to be a problem in modern developed economies over the past two decades inflation has recently reached record highs not seen since the 1970s. With the exception of Japan, which has a rather modest rate of 2.5%, figures from The Economist (July 2022) show all of the world’s major economies are currently facing uncharacteristically high rates:
- USA 9.1%
- UK 9.4%
- Germany 7.5%
- Italy 7.9%
- France 6.1%
- Eurozone 8.9%
Turkey’s inflation rate has shot up to 79.6% and Russia’s is at 15.9%. Even the 2.5% in Japan is significant as it represents a major transition from the deflation that it has been suffering on and off over the past decades.
Causes?
What is interesting regarding these inflation rates is that unlike the inflation of the 1970s which was the result of the OPEC oil price rises, there is little consensus among economists, governments and Central Banks regarding the causes and consequently little agreement about how best to tackle the problem.
There are three main factors that have contributed to the current inflation:
- Demand-pull pressure generated by the expansionary fiscal packages implemented to counteract the deflationary effects of the pandemic lockdowns together with the continuation of monetary expansion through quantitative easing;
- Cost-push pressure as a result of the Russian invasion of Ukraine that has led to significant increases in energy and food prices;
- Supply chain problems relating to the pandemic such as the shortage of chips necessary for car and other manufactured goods production.
Conservative central bankers and neoclassical economists tend to emphasise the demand-pull causes while others prefer to blame the war and the pandemic disruptions. This blame game is unfortunately quite politically motivated which makes it difficult to objectively identify the most important underlying causes. A further complicating factor is the specific factors that affect certain countries. For example, Turkey’s high inflation is closely related to the extensive depreciation of the currency that has caused import prices to increase dramatically, and in the case of Britain, many commentators identify the repercussions from Brexit as an additional determining factor. Germany is especially affected by its greater dependence on Russian oil and gas and consequent restrictions in the supply chain that disrupt manufacturing output.
Why is identifying the exact cause important?
It is important for the selection of the appropriate policy. If the main source of inflationary pressure is on the demand side of the economy, then a contractionary fiscal and monetary policy would be appropriate, and this is the reason why several central banks are raising interest rates and replacing quantitative easing with quantitative tightening. Such policies, however, risk sending the economy into recession and, if the inflation is mainly the result of higher costs of production as a result of rising energy and fuel prices, will have little effect in combatting the inflation.
Paradoxically, the Bank of England has reportedly warned that the UK economy is heading for a prolonged recession and inflation rising to 13% as a result of energy and food price rises resulting from the war (see this article in the Guardian newspaper. It has responded by raising interest rates to 1.75%, which is likely to make the risk and length of recession worse without having any effect on fuel or food prices.
The importance of perceptions
The willingness to sacrifice economic growth and employment in order to fight inflation is a reflection of the psychological impact and perceptions regarding inflation. It quickly becomes a regular news item, generating cost-of-living crisis discussions that keep it at the forefront of public sentiment, and this easily becomes channelled against the government. In response, both the government and the central bank need to be seen to be taking the problem seriously and feel obliged to take some action. The easiest response is to raise interest rates and hope that the war finishes sooner rather than later so that the ensuing recession is minimised.
What are the alternatives?
Unfortunately, there is no quick fix and given that energy and food prices are determined in world markets there is no domestic policy that can directly alter these. Indirectly, it is possible to lower these prices with subsidies or a reduction in indirect taxes on petrol and gas, but governments are reluctant to incur such increased expenditure and revenue losses. Supply-side policies take too long to work and so are not a practical alternative, which leaves raising interest rates as the default option despite its recessionary impact.
Interestingly, the head of the UN recently suggested that the immoral profiteering of the energy companies should be taxed and that the proceeds could be used to compensate the worlds poor against the cost-of-living increases, but for some reason governments think that taxing billions in windfall profits is unfair (further reading in this Guardian article ).
Follow the Fed!
In all fairness, it should be noted that although central banks are independent of their domestic governments, they cannot ignore the actions of the Federal Reserve in the USA. In July 2022, the Fed raised interest rates for the fourth time in a row by 0.75% to 2.5%. These rate increases have led to the dollar appreciating against the pound and the euro, and has the effect of keeping US import prices down while for Europe and the UK the cost of imported energy and food (priced in dollars) increases. This effectively forces the European Central Bank and the Bank of England to raise their interest rates as well in order to reduce the downward pressure on the euro and the pound. This is another reason why raising interest rates is a popular policy measure in dealing with inflation.
A final reason for using interest rates to combat inflation is that it sends a message of intent aimed at reducing expectations of inflation because once people fear that inflation is here to stay these expectations can generate a dynamic element in the inflationary process that becomes difficult to break.
