The current problem of inflation (January 2022)
Our IB Economics author George Graves focuses on inflation in a world recovering from the disruption of the pandemic.
From the financial crisis in 2008/9 to the first two years of the pandemic there was hardly any major economy that experienced problems associated with inflation, and central banks in all developed economies were concentrating on trying to stimulate their economies with an aggressive monetary policy through quantitative easing. This kept interest rates at historically low levels. Rather than struggling to keep inflation below the 2% target many central banks were concerned to increase inflation towards the target so as to avoid deflation.
Since the end of 2021, however, there has been a steady increase in inflation in most countries and fears are being expressed of a return to the high inflation era of the 1970s and 80s. CPI inflation is currently running at 7% in the USA (December 2021), in the UK it is at the highest level since 1992 at 5.4%, and in the EU inflation is 5.2%. Even Japan, which for most of the past decade has experienced deflation, has now recorded a positive inflation rate of 0.6%. Under normal circumstances such relatively high rates of inflation would have produced an immediate reaction by central banks to increase interest rates in order to secure their committed 2% inflation targets.
However, there has been a marked reluctance for this action to be taken for a variety of reasons. Firstly, there is a widespread belief that the current inflationary pressures are temporary and that they will subside over the coming months. Secondly the recovery from the pandemic with respect to growth and employment is still tentative and any sudden increase in interest rates could reverse the recovery. Thirdly, the major source of the inflationary pressure is largely outside the sphere of influence of domestic policy measures being related to energy costs and supply chain problems.
This is why for policy purposes it is better to use measures of underlying or core inflation rather than the CPI measures identified above. At best, a central bank can implement a contractionary monetary policy that will reduce the pressure of demand in the economy. This is an appropriate policy if the inflation is demand-pull in nature. Some of the inflationary pressure is the result of the expansionary policies implemented by governments to boost the economy. If, however, as seems to be the case, the inflation is mainly cost-push and the result of high prices of imported energy, raw materials and food, raising interest rates is not going to be effective as these prices are set in world markets. Core inflation strips out the volatile components of the CPI such as food and energy and will therefore give a clearer indication of the domestic inflationary pressures. In all the countries experiencing high inflation, core inflation will be much closer to the inflation targets of 2% than the CPI inflation.
It is likely that central banks will continue to increase interest rates by modest amounts over the coming months, but they are unlikely to pursue an aggressive policy as there is a strong belief that the supply chain problems associated with the pandemic will quickly be sorted out and that high energy prices will begin to reverse. Timing is crucial because a move too soon could derail recovery while a delay could allow inflation to escalate to dangerously high levels. By the time you write your final exams the picture will become clearer but for now we can only speculate.
