Inflation today – what is the best response?

The Inflation globally has been on the increase and above the target band in most developed economies. This applies to both Headline and Core inflation.

Headline Inflation – all goods and services
Core Inflation – all goods and services excluding food and energy.

Economic theory suggests that inflation could accelerate and return to levels seen in the 1970’s. A lot will depend how policymakers react to the challenge of bringing inflation down to their specific target level – RBNZ 1-3% but CPI in NZ is 5.9%. See chart for inflation breakdown in OECD countries.

Source: IMF

Key reasons for inflationary pressure.

Supply chain bottlenecks: Lockdowns and shipping problems (container shortages) but latterly the demand side has accelerated – economic recovery and demand for durable goods as well as panic buying.

Demand for more goods than services: Much of the inflation has been in durable goods whilst service inflation has only seen a small increase. This is dependent on which country – for instance demand for used cars in the US has soared.

Fiscal and Monetary stimulus: Approximately US$16.9trn of government spending has been injected into the global economy. This is accompanied by expansionary monetary policy (low interest rates) is conducive to more spending and higher inflation. Savings that accumulated during the lockdowns were now being spent. There was a debate between leading economists whether the inflation would be transitory or persistent. It seems that the data now supports those of the persistent camp. Whether it persists depends on central banks.

Labour supply: Labour participation rates have dropped – for instance for every job opening in the US there is only 0.77 unemployed people per job. See previous post – US Economy – potential for wage-price spiral. This is due to continue meaning that there is a job seekers market where there is likely to be pressure on wages.

Russian invasion of Ukraine: Russia and Ukraine are big exporters of food and major commodities so higher prices have been inevitable with major disruptions to the supply either through sanctions or conflict areas. They supply 30% of global wheat exports so prices have been increasing.

Source: IMF

What should central banks do?

Mainstream policy by central bankers should ignore supply-side shocks like higher commodity prices as this is only temporary. When central banks have intervened and raised interest rates they have ended up worsening economic conditions – ECB raising rates post GFC in 2008 and 2011. Already inflation globally is increasing but there is little central banks can do with higher global energy prices. A focus on home grown inflation (core) might be a better indicator to watch as well as the labour market – fast wage growth might mean higher interest rates. Economist John Cochrane argues that bringing down inflation through higher interest rate is a blunt tool, especially when prices have risen predominately through a loose fiscal policy. He states that inflation might get worse if people doubt the government’s ability to repay its debt without a discount from inflation.

Ultimately the outlook for inflation depends on how determined central banks are to rein in inflation and the confidence of the bond market to governments willingness to pay their debts. Below is a good video from the IMF on the inflationary problem.

Sources: IMF – Will Inflation Remain High? The Economist – ‘War and Price’ – March 5th 2022

Oil Shocks – are they bad for the global economy?

Tobias Rasmusses and Agustin Roitman, two IMF economists, in a recent paper have argued that oil shocks are not that bad for an importing country. They have suggested that a 25% increase in oil prices will cause a loss of real GDP in oil-importing countries of less than 0.5%, spread over two to three years.
“One likely explanation for this relatively modest impact is that part of the greater revenue accruing to oil exporters will be recycled in the form of imports or other international flows, thus contributing to keep-up demand in oil-importing economies”
However in considering the impact of higher oil prices one must look at what caused them to rise in the first place. There have been supply-side and demand-side reasons.

1973 – 400%↑ – supply-side– Yom Kippur War oil embargo
1979 – 200%↑ – supply-side – Iran Iraq War
1990 – 50%↑ – supply-side – Iraq War
2000 – 75%↑ – demand-side – Global growth.

What it is important to remember is that when there is higher global growth there likely to be higher oil prices, which is a positive. Supply-side policies also play a role – 1970’s and 1990-91 – especially the disruption to supply in Libya this year. “Finding that the negative impact of higher oil prices has generally been quite small does not mean that the effect can be ignored.”
Rasmusses and Roitman do not rule out more adverse effects from a future shock that is driven largely by lower oil supply than the more demand-driven increases in oil prices that have been the norm in the last two decades.