By Rodrigo Antón García, Third Year BSc Economics
We have seen a very strong recovery after the pandemic in 2021, but markets are now starting to shake again. What is behind the current record-high inflation? Is Russia’s invasion of Ukraine the major influence? Will the measures that have been usually adopted by central banks sufficient to tackle this inflationary crisis?
Post-pandemic inflation is mostly transitory, but it will take some time before improving. After all, if economists ‘agree’ on something it is that prices take time to adjust, time lags are, as their name suggests, sluggish, and expectations are tamed with, yet again, some more time. This has only become worse with the turmoil across the European continent, where Russia’s invasion of Ukraine has caused the prices of oil, gas, wheat and other commodities to soar, and what is worse for inflation in particular, an increased uncertainty of what the future holds.
The chart below offers a quick summary of what once were, back in February, the possible economic scenarios following the Russian invasion of Ukraine. A posteriori, the moderate and severe columns were largely correct, especially with regards to European gas and oil reliance. To this date uncertainty remains more than prevalent. The challenge of finding alternative energy sources and achieving subsistence in a short-run window has been pushed across our agendas with no evident success. Moreover, the ‘energy’ summer cushion is now coming to an end as forty-degree temperatures in the UK will become anecdotes of a cold and energy-reliant winter. And so, for many of us, it is evident that current inflation has a clear and worrying interpretation: the looming result of unpredictable supply as well as changing political discourse and economic (or Nord Stream) debate.
Figure 1. Scenarios for economic impact of Ukraine Crisis. (1)
However, inflation was already powerful before the current energy supply shocks. By March, official measures of the cost of shelter across the US still did not fully reflect the surge in the cost of newly rented apartments (2), which strongly suggested a lot of ‘to be expected’ inflation in the pipeline. The same structural analysis also underlined parts of the European economy, particularly in the UK and some Scandinavian countries. Nevertheless, this was not the case for most peripheral European economies. If we consider Spain, which was predicted to have a somewhat quiet recovery after the pandemic, and hence slowly moving prices, inflation largely took over after the invasion, where rising fuel prices by over 25% quickly forced the PM to announce a 20-cent discount per litre of fuel for all drivers in Spain (3). Ultimately, despite the list of inflation causes across most Western economies being non-exhaustive and prone to confounding effects, if anything what we can observe is a compounded inflation reaction.
The following chart shows the annual UK CPI inflation rate with a highlight on post-pandemic eras. During these recovery periods, historical data shows that inflation has typically fallen by wide margins and, most notably, without the possibility of inflation-targeting being enforced by the Bank of England. However, the current inflationary noise offers a stark contrast. It is not only heavily influenced by strong and unexpected supply-shocks, but also tangled in an extraordinarily interdependent and globalised economy. The use of past data for current analysis may therefore be deemed of low interest, perhaps with the exception of price falls implying quiet consumer behaviour and the attitudes of post-pandemic animal spirits. Withal, as we mentioned before, this rhetoric is now also to account for the effect of inflation-targeting, which makes the threat of sporadic changes in inflation more controllable. Let us closely look at how this mechanism can calm down inflationary fear and uncertainty.
Figure 2. Annual UK CPI Inflation (4)
Inflation targeting is central to understanding plausible getaways from inflationary spirals; possibly the only violation of Goodhart’s law - that “when a measure becomes a target, it ceases to be a good measure”. Looking back at the OPEC crises of the past century, abrupt and costly cold-turkey approaches, involving a sudden change in policy, proved to be largely inefficient, where the high cost of unemployment was not comfortably offset by accompanying monetary policy and even less by Norman Tebbit’s "Get on yer bike!" statement - a major British mantra of free-market dichotomy. In gross terms, this was largely caused because the supply-side effect of the shock was not fully understood by economists. Thus the economy moved in an inflation and depreciation spiral that did not enable the economy to reach a steady-state in a short period of time. The observed economic cycle was at its heart an inefficient cycle: as inflation kept rising, home competitiveness fell, which produced real appreciation with respect to other economies causing output to fall through higher-priced exports, and so, requiring again looser monetary policy which depreciated the currency further.
Luckily, with inflation-targeting active in most economies after 1992 this is no longer the case. Nowadays most central banks do not only try to ‘control’, but instead ‘target’ inflation, cooperating with the foreign exchange market and creating the necessary confidence for markets to adjust appropriately. This enables the adjustment process of monetary policy to work more smoothly and improves the credibility of central bank action.
Moreover, current inflation is not self-perpetuating as it was back in the 1980s. In simple terms, while current consumers do still expect high inflation over the next few years, their longer-term expectations remain “anchored” in the long-run at more fairly moderate levels relative to their predecessors. In fact, most professional forecasters expect inflation to moderate at much faster rates. This is highly significant since inflation is tied with expectations, thereby its prediction being sometimes as important as, if not more than, analysing its serial correlation through conventional modelling.
Figure 3. US 5-year Forward Inflation Expectation Rate.(5)
To be more precise, we shall note that the measures to control inflation have not only improved but also become more assertive and clearer for market participants. Therefore, although a soft landing may no longer be a guarantee, its probability has certainly increased. This is exemplified by the introduction of Forward Guidance in 2013 in the UK, a simple and convenient mechanism whereby the Bank of England communicates to the public the likely future course of monetary policy. This is one of the driving factors of why investment confidence remains high as compared to other neighbouring European nations. Crossing the Atlantic, the argument remains even stronger, Janet Yellen, Biden’s Treasury Secretary, clearly asserts her position: “I have spent many years studying inflation … and I can tell you we have the tools to deal with that risk if it materializes”. (6)
All of this has resulted in changes in the interest rate by central banks being highly credible in past years, which is fundamentally necessary to tackle conflicts with inflation, particularly when going against the consumer’s favour and requiring tighter policy. Jay Powell, Chairman of the Fed highlighted this point in one of his recent speeches on the 16th of March (2022).
“In particular, if we conclude that it is appropriate to move more aggressively by raising the federal funds rate by more than 25 basis points at the meeting or meetings, we will do so. And if we determine that we need to tighten beyond common measures of neutral and into a more restrictive stance, we will do that as well”. (7)
Figure 4. Powell effect on Expected Interest Rates.(8)
Keeping all of this in mind, it goes without saying that we should not take the central banks’ word and confidence, together with the expected behaviour of what will happen as the only truth. The war could further worsen the situation for many European economies and the US could prove to be running an even more unsustainable hot job market than it is already doing. This implies that many governments will probably have to accept an increase in the unemployment rate, perhaps some negative growth, but not a tragic full-scale recession. The bottom line is that current inflation looks very different, and much easier to solve than past inflation, in particular when compared to the headaches of the 70s’ stagflation.
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DISCLAIMER: All opinions and analyses are the author’s own. We do not intend to harm, offend, or ridicule any person or community through our writing.