After a long period in which almost everyone has been too complacent with inflation, the tide may finally be about to change. Inflation is now approaching faster and falling faster than many expect, even in ‘Brexit Britain’.
It is true that this is partly a reflection of the extent to which inflation has already risen. The main measure of consumer price inflation in the UK was 9% in April. It is widely expected to increase further in the fall, when Ofgem’s price cap is updated on domestic energy bills. The alternative measure of RPI is already above 11 pc.
Other countries have also experienced a sharp rise in the cost of living. Inflation is now above 8% in both the US and the euro area. Within the EU, inflation is around 10% in Belgium and the Netherlands. The average for all OECD members in April was 9.2%.
What next? To predict the future we must understand how we got here. This puzzle has three parts: the strength of demand, the shocks of supply, and the role of monetary policy. The third is often overlooked, but potentially the most important.
The strength of demand has been at least “good news.” It seems like a while ago, but remember that the global economy, and the UK in particular, was recovering faster than expected from the pandemic, aided by the successful deployment of vaccines.
Central banks underestimated the resulting demand inflation, in part because they expected a much weaker recovery. But they also relied too heavily on simple “output gap” models that assumed inflation would remain moderate while the general level of economic activity was still well below its pre-Covid trend. This gave too little weight to the dislocation of the activity and to the intensified pressures in sectors still open.
Supply shocks have also played an increasingly important role. Even before the last invasion of Ukraine, supply chain problems and labor shortages increased cost-driven inflation. Russian aggression has exacerbated these pressures, especially in commodity markets, from energy and metals to agricultural products, including wheat and vegetable oils.
Finally, all this has been facilitated by a long period of excessively weak monetary policy, with the US Fed, the European Central Bank and the Bank of England, all continuing to inject large sums of money into economies that were already overheated. .
This part of the explanation for higher inflation is crucial and often missing. Without this additional monetary stimulus, rising inflation in scarce goods and services would have been offset by lower inflation elsewhere. The loss of credibility has not helped either, due to its impact on inflation expectations.
Now, there are reasons for optimism on all three fronts. The global economy is slowing and, while this is “bad news” in other respects, it will at least ease some of the pressure of demand.
More positively, supply-side pressures may also be declining. Part of the cure here is simply the passage of time. Prices have been high for many months now, providing both the incentive and the opportunity for consumers to find alternative sources and for producers to increase their production. Higher wages are also part of the solution to labor shortages.
In fact, there are already some tentative signs in commodity markets and business surveys that prices are stabilizing, supply disruptions are beginning to ease, and pressures on input costs are reaching maximum. The recent lifting of Covid restrictions in China will also help.