After decades of barely-there inflation, a mix of issues resulting from the pandemic and the war in Ukraine has created the perfect storm for excessive inflation, writes Jim Power.
A total lack of inflation has characterised the developed world economy for the past decade. Many central bankers have been focused on generating inflation using historically low interest rates and quantitative easing (QE), a mechanism for keeping long-term interest rates down and injecting liquidity into the financial system.
Indeed, the Japanese have spent 30 years trying to break a deflationary spiral.
Economists still do not fully understand the mechanics of inflation. However, it seems clear that the lack of inflation in recent years can be attributed to a combination of factors:
- Globalisation;
- The emergence of very low-cost producers of goods in the developing world, particularly in areas such as clothing and white goods;
- Intense retail competition, particularly in the online sphere (Amazon, in particular);
- Waning power of trade unions;
- The growth of technology; and
- The impact of the great financial crash and the policy of fiscal austerity that followed.
All has changed over the past year. Inflation has come back with a vengeance – the annual rate in the eurozone now stands at 7.4 percent; 8.5 percent in the US; seven percent in the UK; and 6.7 percent in Ireland, the highest rate recorded since October 2000.
Demand-pull vs cost-push
Traditional economic theory suggests that inflation is either demand-pull or cost-push.
Demand-pull means that there is excess demand in the system, and the prices of goods and services are bid up as supply fails to match demand.
The Irish housing market is a good example of demand-pull.
Cost-push inflation arises when input costs, such as labour and raw materials, increase in price. The two oil price shocks in the 1970s provide a good example of this phenomenon for those of a certain age.
The resurgence of inflation over the past year is primarily an example of inflation driven by supply difficulties, but there is also an element of demand-driven pressures.
A crisis upon a crisis
We have experienced a very unusual set of circumstances over the past couple of years. During the COVID-19 pandemic, production was significantly disrupted against a background of restricted demand and the shutdown of many businesses. There were also significant problems with shipping and logistics due to the COVID-19 restrictions.
When economies started to re-open, repressed demand was unleashed into the system, and this resurgence in demand came up against supply constraints. Prices began to rise, something particularly evident in energy markets.
At the beginning of this year, the view was that as the post-COVID world returned to some semblance of normality, the supply bottlenecks would sort themselves out, the resurgence of repressed demand would ease, and inflation would come back down.
Unfortunately, we have been reminded that we should always expect the unexpected in recent weeks.
The Ukraine war is causing serious supply issues in energy, wheat and other foodstuffs, fertilisers and many industrial metals. A crisis has come upon a crisis, and the transitory inflation problem is now looking more long-lasting.
Excessive inflation
Excessive inflation is a problem on several fronts.
If the rate of price increase exceeds the growth in wages, real incomes decline, and people’s purchasing power is damaged. This is a particular problem for those on fixed incomes, such as pensioners.
For a small open economy like Ireland, if inflation here is rising faster than countries with which we trade or compete, international competitiveness is eroded.
On the plus side, Ireland’s inflation problem is not unique – everybody else is grappling with the same problem.
In Ireland, prices increased by 6.7 percent in March. Of this 6.7 percent increase:
- housing, water, electricity and gas contributed 2.76 percent, due to higher electricity, gas and rent costs;
- transport contributed 2.4 percent, due to higher oil prices;
- alcohol contributed 0.41 percent due to the introduction of minimum unit pricing in January this year; and
- restaurants and hotels contributed 0.53 percent due to wage pressures and higher energy costs.
It is clear that energy has been the big driver of inflation, but it is now starting to become more deeply ingrained as the Ukraine war continues and labour shortages cause wages to rise.
The likelihood is that food price inflation will increase over the coming months due to rising food production costs and wheat prices. The possibility of the scarcity of products such as rice and sunflower oil is also high. Intense retail grocery competition might just put some brake on these price pressures.
Breaking the cycle
One of the problems with inflation is that it can become embedded in people’s expectations, causing them to seek higher wages which, in turn, feeds through to higher prices.
History shows that the persistence of inflation increases as the rate rises. Central banks and governments will have to work hard to break this cycle and make tough decisions with interest rates, taxation and government spending. Populist cash giveaways are not the way to respond.
Inflation and its causes are now the dark clouds threatening the economic outlook.
Jim Power is and Independent Economist and host of the podcast, The Other Hand.
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