For the past ten years, inflation has been low, below the targets set by most central banks in developed countries. They tried everything, including instruments never used before, but nothing worked: they couldn’t bring up the inflation rate. Suddenly, inflation arose without warning, and the question of purchasing power became paramount. But where does it come from? As you might expect, the debates are raging, justifying a brief overview.
There are those who had warned us for years. They watched the central banks multiply the quantity of money they create by two, then four and more in a few years (in the United States and in the euro zone, there are more than seven since the beginning of 2008). They had learned that the level of prices faithfully follows the quantity of money after a delay of a year or two, and they predicted, year after year, spectacular inflation.
Their unshakable faith is now being rewarded: inflation is here. Except that we are very far from the 50% or 100% that their theory predicts. Except that after years of badly mistaking it, they should explain why it’s coming so late; but they don’t seem to have understood why they were wrong.
There are the central banks, which assured a few months ago that this sudden rise was strictly temporary, excluding any action to fulfill the core of their responsibility, price stability. While some central banks have admitted to being seriously mistaken and are finally moving, the ECB remains on its “temporary” line. She also recognizes her mistake, but she maintains her Olympian calm and only begins to admit half-heartedly that she has to get started, but not right away, and very slowly. According to her, Europe is different.
There are those who flip the table 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 colossal aid to individuals and businesses. Demand has exploded since the end of the first wave of Covid-19, sporadically stalled by successive waves. Quite naturally, therefore, the prices increase. You have to admit that they are the only ones to have foreseen what is happening.
And then there are those who accumulate explanations to assert that this rise was unpredictable. They tell us about surprising bottlenecks in long production chains, which include myriad producers spread all over the globe. Whether one of them cannot keep up, or whether the ports are suddenly congested and the boats too few to carry what is available, and it is a cascade of blockages that make those who assemble all these intermediate products are unable to do so.
They also tell us about the rise in the price of raw materials, including gas and oil, which make everything more expensive. And now there is the war in Ukraine which is blocking deliveries of sunflower oil and cereals. The supply is not there and the prices are going up.
Explanation, step by step
If you are lost, rest assured, you are not alone. But it is possible to separate the tree from the forest and to envisage a coherent story, because each of these explanations has its share of merit. Simply, the case is richer than these fragmentary explanations.
Remember the pandemic. We cut spending because we were confined, because we were scared, because the future was intensely uncertain. Revenues were protected by budget support. With incomes maintained and expenses reduced, personal and corporate savings increased significantly and, once the pandemic was under control, they were available to make up for lost time.
Add the government spending that continues to ensure the recovery and it becomes normal to see demand explode. As, opposite, supply got back on track more slowly, hampered by bottlenecks, inflation began to climb.
The supply recovery has been particularly slow for most extractive industries. Commodity prices rose sharply, and this increase gradually trickled down to consumer prices. The cost of labor has also started to rise as it is necessary to bring back employees who had become accustomed to staying at home and were reluctant to work in strenuous activities. The central banks considered that all this would fade and therefore that the rise in inflation would be temporary. It was plausible, but far from certain. They made two mistakes.
The first was to imagine that wages would remain stable. However, the rise in inflation represents a loss of purchasing power for employees. Central banks believed that the surprising wage moderation of the last decade would continue, but this is no longer the case in some countries and unlikely in Europe. Even if the past causes of the resumption of inflation were to come to an end, the price increases already garnered have seriously eroded the purchasing power of employees. The success of Le Pen and Mélenchon in hammering out this question illustrates well the importance of this question.
The second error was a lack of prudence, or modesty. Faced with an unprecedented situation, economic forecasts are unusually fragile. The scenario of a wage increase was just as plausible as that of a temporary inflationary surge. Central banks should have been less sure of their forecasts and they would have been well advised to work on several scenarios. Having made such a mistake, they now see their credibility suffer.
The real surprises
To make matters worse, Russia was on the move. Preparing his “special military operation” from the beginning of the autumn, it slowed down its deliveries of gas and oil. It has insured its long contracts but has practically stopped accepting short contracts which are used to deal with temporary fluctuations, in particular those which anticipate winter needs. Prices have risen dramatically. The invasion of Ukraine obviously increased the pressure.
China, which supplies the world with intermediate products, has also aggravated the situation. Its “zero Covid” policy involves the sporadic closure of thousands of businesses. The cost for China is considerable – it is probably going into a recession these days, not seen for half a century – but the impact on the rest of the world is significant insofar as it creates bottlenecks .
Further waves of Covid are always possible. The first effect will undoubtedly be to reduce demand and thus moderate inflationary pressure. Already, moreover, the war in Ukraine worries enough to reduce consumption. The specter of stagflation, the uncomfortable conjunction of high inflation and a recession, is becoming more and more obvious.
For those worried about inflation, this is rather reassuring because it should push inflation down. The price to pay will be a rise in unemployment. It will then remain to be seen whether governments again feel compelled to widen their deficits to protect their citizens and businesses. Upon recovery, the current situation could recur.
Now that the hypothesis of strictly temporary inflation has vanished, what next can we envisage? Beyond the role of budgetary policies and surprises, good and bad, on the horizon of two or three years, it is monetary policy that will play the main role. Apart from the ECB, no doubt temporarily, the central banks of the developed countries seem determined to bring down inflation before it becomes encysted. In the past, before the global financial crisis, the operation was simple: all you had to do was raise interest rates sufficiently. It is different today, and this is where we will find the debate on the link between money supply and inflation.
The reason why the money supply could be massively increased without creating inflation is important. Normally, a central bank creates money by lending it to commercial banks, which then rush to lend that money back to their customers—in fact, multiple times. It is these bank loans that fuel demand and inflation.
However, since 2008, this process has largely been blocked. Firstly because the banks have been weakened by the financial crisis, then because new regulations lead them to be more cautious, finally because individuals and companies had no use for massive loans. The result is that commercial banks today are sitting on gigantic amounts of currency, which they can lend to their customers. The sums are such that the process could be explosive.
Central banks are aware of this, of course. To block this process, they have two instruments: the rise in interest rates, which discourages borrowing, and the reabsorption of the monetary mass that they have created. They must use both, but they will be subjected to strong hostile reactions. Interest rates will have to go up much more than is assumed at this time. They will have to rise above inflation, otherwise the real cost of borrowing is negative.
Even though 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 were to spontaneously fall back to 3%, which is optimistic, central banks would have to set their rates at at least 4%, which means rates of at least 6% for individuals. No one imagines that today, especially not heavily indebted governments.
As for the money supply created by the central banks, multiplied more than seven times, as we have seen, it served to stabilize the financial markets (and drive up share prices) battered by the 2008 crisis, then by the public debt crisis in the euro zone, then by the pandemic and now by the war in Ukraine. Reducing the money supply to reduce the risk of a credit boom could weaken the financial markets and raise the specter of a new crisis. Even the central banks most determined to tackle inflation have not yet displayed ambitious intentions on this issue.
A new era
Clearly, we have entered a new era in inflation and monetary policy. A whole generation has lived with price stability. Central banks have developed strategies geared towards this objective, made possible by their independence from governments.
Strengthened by their prestige, they then took on new responsibilities, such as financial stability, sometimes without sharing. Some, like the ECB, have displayed ambitions in the fight against climate change. In the United States, the Federal Reserve has even announced that it is concerned about income distribution.
But the wheel has turned. They have endeavored to bring up inflation, which has become too low in relation to their objectives, by inventing new instruments: negative interest rates and the massive creation of money. It did not work. Then, after years of too low inflation, they did not see too high inflation coming. Here they are called back to their primary mission: price stability.