Global Inflation: Is the Fairy Tale Beast Back to Haunting us?

If you are a regular at Brioche Dorée, the recent 10% price increase of the student deal might have been catastrophic news. In fact, a double-digit inflation rate is becoming a reality in the developed world, with the Organization for European Economic Co-operation (OECD) average annual rate reaching 7.7 percent in March 2022. With the United States experiencing its highest level of inflation since 1981 and Europe following closely, inflation, a phenomenon that many economists claimed was long gone, seems to be back. But how worried should we be?

Why is inflation back?

The rise in inflation caught many economists and central banks off guard – as a matter of fact, nearly none of the central bank inflation forecasts in the developed world were accurate for 2021. This is surprising, as the recovery from the economic downturn of the pandemic signaled increased pressure on both the demand and supply sides of economies. Simply put, today’s inflation is the result of too much money chasing too few goods: an inevitable outcome of the economic policies of the pandemic era.

The demand-side inflation (also known as demand-pull inflation) is, in large part, related to the drastic aggregate demand recovery fueled by the stimulus packages distributed by governments during the pandemic alongside the overall global employment recovery. The US federal government passed stimulus packages that injected more than 4.5 trillion dollars into the economy, with the EU following up with a package of 2 trillion euros. With many investing their stimulus money on mid- to long-term assets - such as government bonds, stocks, gold, and real estate - demand-side pressures increased prices for these highly attractive assets. In fact, all American indices have passed far beyond their pre-pandemic levels, signaling an unprecedented demand recovery from the pandemic. As the economy on the demand side is stronger than ever, theories suggest inflation should be expected. Though one might then ask: “how has the developed world grown at a stable rate for years while keeping inflation at bay and maintaining low unemployment and minimal monetary intervention?” The difference this time is that the pressure is on the supply-side.

The impact of the pandemic was more drastic on the supply-side compared to demand-side simply because short to mid-term adjustments in supply tend to be more inelastic than demand-side adjustments. For example, the ongoing electronic chip shortage can be partly attributed to the automakers’ decision to slash orders during the early stages of the pandemic which led chipmakers to switch their products to fit the surging demand for consumer electronics. As the aggregate demand recovered, the supply of cars is now drastically halted due to the chipmakers' unwillingness and inability to switch their supply back to the automotive sector. This caused a spillover demand for substitutes, resulting in a 20 percent price increase in the second-hand car market in the US.

Moreover, disruptions to supply chains triggered by the pandemic are now exacerbated by political tensions spurred by the Ukrainian war. The increase in energy prices has reached, on average, 27 percent in OECD due to the political tensions surrounding oil and natural gas supply. This cost-push inflation is only aggravated by the cutting of government subsidies to many sectors – subsidies that were instrumental in the survival of many businesses during the economic fallout of the pandemic.

What to expect now?

While the dramatic increase in inflation is worrying for many, central banks have been cautious in implementing monetary policy to combat rising inflation. Throughout 2021, the consensus among the developed world was that the increase in global inflation was temporary and would eventually fade out as market forces settle around pre-pandemic levels. The higher-than-usual inflation rates could also be attributed to the unusually low commodity prices in 2020 caused by the demand fallout which would have given rise to unnatural inflation once demand and prices returned to pre-pandemic levels. However, recent political developments in commodity markets are forcing central banks to take action. The US Federal Reserve had already started tapering its quantitative easing policy by the end of 2021, effectively increasing real interest rates without changing their near-zero policy rate. Leading emerging markets have also responded to inflation throughout the year, with many increasing policy interest rates by couple hundred basis points - a move that the developed world resisted to take.

Nevertheless, by March 2022, the Federal Reserve was forced to increase its policy rate for the first time since 2018, an action soon replicated by the Bank of England. The Fed also signaled further increases in the policy rates up to 3.5 percent, citing the dangers of high inflation. Central banks around the developed world now hope to raise rates rapidly to avoid a “hard landing.” However, many are skeptical about central banks’ ability to use monetary policy effectively without causing a recession. Considering the track record of the Fed, recession risks are no doubt elevated, creating a low morale in the world of economics. As inflation is affected by expectations as much as by market forces (if not more), pessimism and distrust in the market could be the biggest worry of all. With the European Central Bank also signaling a potential switch from its zero-interest policy, the future is more unclear than ever. The question is, can the West curb its inflation as successfully as Japan or is it leading to a catastrophic fallout like Turkey? The answer, as with everything else, will probably lie somewhere in between.