Over the past ten years, inflation has been low, below the targets set by most central banks in developed countries. They tried everything, including tools that had not been used before, but nothing worked: they could not raise the inflation rate. Suddenly, inflation appeared without warning, and the issue of purchasing power became the priority. But where did it come from? As you might expect, discussions are heating up, which justifies a brief overview.
Some have warned us for years. They have watched central banks multiply the amount of money they create by two, then four or more in a few years (in the US and in the eurozone, there are more than seven since the beginning of 2008). They have learned that the price level faithfully follows the quantity of money after a delay of a year or two, and they have predicted, year after year, staggering inflation.
Now their unwavering faith is rewarded: inflation is here. However, we are very far from the 50% or 100% that their theory predicts. Except that after years of blundering, they must explain why it was late; But it seems that they did not understand why they were wrong.
There are the central banks that confirmed a few months ago that this sudden rise was completely temporary, ruling out any action to fulfill the essence of their responsibility, which is price stability. And while some central banks have admitted they are seriously wrong and are finally moving, the European Central Bank remains on its “temporary” line. She also realizes her mistake, but maintains her Olympic calm and only begins to lukewarmly admit that she should start, but not immediately, and very slowly. According to her, Europe is different.
There are those who turn the tables on the link between money and inflation to explain that governments, not central banks, are to blame. All governments have practiced “whatever it takes” since the start of the pandemic. They borrowed heavily to distribute huge aid to individuals and businesses. Demand has exploded since the end of the first wave of Covid-19, interrupted intermittently by successive waves. It is normal for prices to go up. You have to admit that they are the only ones who anticipate what is going on.
Then there are those who gather interpretations to assert that this rise was unpredictable. They tell us about sudden bottlenecks in long production chains, which include countless producers spread all over the world. Whether one can’t keep up, or whether the ports are suddenly crowded and the boats are too few to carry what’s available is a series of obstacles that render those who collect all these intermediate products unable to do so.
They also tell us about the rising prices of raw materials, including gas and oil, which makes everything more expensive. And now there is a war in Ukraine that prevents the delivery of sunflower oil and grain. Supply is lacking and prices are rising.
step by step explanation
If you get lost, rest assured, you are not alone. But it is possible to separate the tree from the forest and depict a coherent story, because each of these interpretations has its share of advantages. Simply put, the case is richer than these fragmentary explanations.
Remember the epidemic. We cut back on spending because we were cornered, because we were afraid, because the future was so uncertain. Revenue was protected through budget support. With incomes maintained and expenses low, personal and corporate savings increased exponentially, and once the pandemic was under control, they became available to make up for lost time.
Add in government spending that continues to ensure recovery and it becomes natural to see demand explode. In turn, the supply got back on track more slowly, because of the bottlenecks, inflation began to rise.
Supply recovery has been particularly slow for most extractive industries. Commodity prices rose sharply, and this increase gradually crept into consumer prices. The cost of labor is also starting to rise because it is necessary to bring back employees who used to stay at home and were reluctant to work in strenuous activities. The central banks considered that all of this would fade away and therefore the rise in inflation would be temporary. That was reasonable, but far from certain. They made two mistakes.
The first is to imagine that wages will remain stable. However, rising inflation represents a loss in the purchasing power of employees. Central banks believed that the sudden moderation of wages in the past decade would continue, but this is no longer the case in some countries and unlikely in Europe. Even if the previous reasons for the resumption of inflation are over, the price increases already charged have seriously eroded the purchasing power of employees. The success of Le Pen and Melenchon in asking this question well illustrates the importance of this question.
The second mistake is lack of wisdom or modesty. Faced with an unprecedented situation, the economic outlook looks unusually fragile. The wage increase scenario made just as much sense as the temporary inflationary rise scenario. Central banks should have been less confident in their forecasts and would have been better off working on several scenarios. Having made such a mistake, they now see their credibility damaged.
To make matters worse, Russia was on the move. getting ready for it “special military operation” Since the beginning of the fall, it has slowed its shipments of gas and oil. It has secured its long contracts but has practically stopped accepting short contracts which are used to deal with temporary fluctuations, particularly those that anticipate winter needs. Prices have risen significantly. Obviously, the invasion of Ukraine increased the pressure.
China, which supplies the world with intermediate products, has also exacerbated the situation. Its “zero COVID” policy includes intermittent shutdowns of thousands of businesses. The cost to China is significant – it’s probably entering a recession these days, not seen in half a century – but the impact on the rest of the world is as great as it creates bottlenecks.
Other waves of Covid are always possible. The first effect will undoubtedly be a reduction in demand, thus relieving inflationary pressure. Moreover, the war in Ukraine is already worrying enough to reduce consumption. The specter of stagflation, the uncomfortable coupling between high inflation and stagflation, is becoming more and more apparent.
For those worried about inflation, this is somewhat reassuring as it should push inflation down. The price to be paid will be an increase in unemployment. Then it will remain to be seen whether governments once again feel compelled to widen their deficit to protect their citizens and businesses. Upon recovery, the current situation can be repeated.
Now that the temporary inflation hypothesis has completely disappeared, what then can we imagine? Besides the role of budgetary policies and surprises, both good and bad, on the horizon of two or three years, it is monetary policy that will play the main role. Aside from the European Central Bank, there is no doubt that central banks in developed countries, for the time being, seem determined to bring inflation down before it becomes crypto. In the past, before the global financial crisis, the process was simple: All you had to do was raise interest rates enough. It is different today, and here we will find the debate about the connection between money supply and inflation.
The reason for increasing the money supply so dramatically without creating inflation is important. Typically, the central bank creates the money by lending it to commercial banks, which then rush to re-lend that money to their customers — in fact, multiple times. It is these bank loans that fuel demand and inflation.
However, since 2008, this process has been greatly hampered. First because banks have been weakened by the financial crisis, then because new regulations are leading them to be more cautious, and finally because individuals and companies have had no interest in the huge loans. The result is that today’s commercial banks are sitting on huge amounts of currency, which they can lend to their customers. Amounts such that the process can be explosive.
Central banks are aware of that, of course. To impede this process, they have two tools: rising interest rates, which discourage borrowing, and reabsorption of the monetary mass they created. They should use both, but they will experience strong hostile reactions. Interest rates should be much higher than they are supposed to at this time. They will have to rise above inflation, or else the real cost of borrowing will be negative.
Although the current spike in inflation is temporary, it means interest rates that we haven’t seen in a very long time. For example, if inflation automatically drops to 3%, which is optimistic, then central banks will have to set their rates at at least 4%, which means rates of at least 6% for individuals. Nobody imagines that today, especially not the indebted governments.
As for the money supply created by the central banks, it multiplied more than seven times, as we have seen, it led to the stability of the financial markets (and the raising of stock prices) that were hit by the 2008 crisis, and then the public debt crisis in the Middle East. The eurozone, then the epidemic and now the war in Ukraine. Reducing the money supply to reduce the risk of a credit boom could weaken financial markets and raise the specter of a new crisis. Even the most insistent central banks on tackling inflation have yet to show any ambitious intentions on the issue.
It is clear that we have entered a new era in inflation and monetary policy. An entire generation has lived with prices stable. Central banks have developed strategies directed towards this goal, which are made possible thanks to their independence from governments.
As their standing has strengthened, they have taken on new responsibilities, such as financial stability, sometimes without involvement. Some, such as the European Central Bank, have shown ambitions in the fight against climate change. In the United States, the Federal Reserve announced that it is concerned about income distribution.
But the wheel turned. They sought to provoke inflation, which had become too low for their goals, by inventing new instruments: negative interest rates and massive money production. It does not work. Then after years of very low inflation, they didn’t expect inflation to be so high. Here they are called upon to return to their primary task: price stability.