Can we tame inflation?

With inflation rates rising and interest rates remaining stubbornly low, policymakers have some tough decisions to make


Having seen operational costs rise by up to 15 percent since last summer, Clearly Drinks, a UK soft drinks manufacturer, had no other option but to increase the prices of its fruity water bottles by at least five percent. “Price rises and inflation have been on the horizon for quite some time now, but businesses are really starting to be significantly impacted,” says a despondent yet hopeful Claire Conolly, chief financial officer at the Sunderland-based company, adding: “As a manufacturing business, we have to be extremely agile and work smarter to remain a profitable business.”

Like many other businesses affected by inflation, the company has to improvise to stay competitive, investing in new technology and looking at different suppliers to bring costs down. But is that enough to chug along until the current wave of inflation fizzles out? “The firm has managed to continue its sustained growth against the difficult economic backdrop,” Conolly says. “We are hoping that these measures can be maintained for the long term.”

An old problem returns
Like Clearly Drinks, many businesses around the world are wondering how long this period will last. Inflation across the EU is expected to reach 6.8 percent this year, above the ECB’s two percent target. The UK, burdened with Brexit-linked inflationary pressures, saw inflation reach nine percent this April, a four-decade record. The picture is similar in the US, with inflation peaking at 8.3 percent, despite showing signs of slowing down in late spring. Global inflation more than doubled compared to last year and is forecast to land at a whopping 6.2 percent, according to the International Labour Organisation.

One reason why the current bout of high inflation has caught policymakers and central banks off guard is its previous absence from public discourse. Just before the pandemic threw the global economy into disarray, the economic press was exploring the opposite question; in 2018, The Economist ran an article entitled ‘Where did inflation go?,’ an allusion to historically low levels of inflation. “In the 20th century, inflation was almost a chronic problem. In the 21st century we thought we had got rid of it, but it now seems to return,” says Michel-Pierre Chelini, an expert on the history of inflation teaching at the University of Artois, adding: “This is the first time in the 35 years we have used annual indices that prices have really risen above a meagre one or two percent.”

Life struggles to return to normal in Shanghai as the pandemic lockdowns continue

Indeed, in the past decade, inflation in the eurozone only temporarily surpassed the two percent threshold; crisis-hit countries such as Greece sustained years of deflation. During the same period, the US experienced only one year of inflation higher than two percent (see Fig 1). The pandemic consolidated this trend, disrupting global supply chains and wiping out whole sectors, such as hospitality.

Most economists expected the turmoil to end in 2021, with the advent of vaccines offering a semblance of economic normality. Rating agencies were confidently predicting a solid economic recovery, enabling businesses and consumers to return to their pre-Covid habits. Some experts even forecast the advent of the new ‘roaring 20s,’ a reference to the interwar period of prosperity.

It was not meant to be. A confluence of events, including the war in Ukraine, a resurge of the pandemic in China, and post-Covid supply chain blues, has poured cold water on optimistic forecasts. Currently, the World Bank expects global growth to reach 2.9 percent this year, down from 4.1, while the IMF has downgraded its forecast for 143 countries.

Inflation lies at the heart of the problem, eating away at living standards across the world. Although economists now agree that high inflation is not a temporary phenomenon, they are divided on its origins, an issue that has taken on a political life of its own. Some point to supply-related reasons, such as choked ports and microchip and energy shortages. “Policymakers assumed that the initial drop in aggregate demand would have been long-lasting, while the negative supply-side effects of the pandemic were initially expected to be temporary,” says Alessandro Rebucci, an economist at Johns Hopkins University. “It turned out that the exact opposite happened, and nobody could have predicted that in 2020 or early 2021.”

Constrained supply may be linked to the shrinking number of employees returning to the office. With an increasing rate of retirement among older generations and a big chunk of workers skipping sectors like hospitality altogether, a trend dubbed ‘the Great Resignation,’ unemployment has hit record lows in many advanced economies. The US labour market is showing signs of overheating, with over five million job vacancies remaining unfilled.

Many economists, however, point to increased aggregate demand as the culprit, due to an unexpectedly rapid recovery. Government handouts to workers protected disposable income at a time when consumption was artificially constrained, creating excess savings; in the US, fiscal stimulus totalled $2trn just in 2021. “The amount of support that was provided on both the monetary and fiscal side in terms of stimulus has led to extremely strong aggregate demand, and that is as important, if not more important than supply,” says Robert Rich, Director of the Center for Inflation Research at the Federal Reserve Bank of Cleveland.

China’s Covid woes
One reason why experts expect inflation to persist and global growth to stall is China’s lacklustre economic performance. The Asian country is facing a renewed phase of Covid restrictions, with lockdowns in industrial hubs holding up production. Restrictions in Shanghai, a city that handles a fifth of China’s trade, may exacerbate global supply chain pressures and drive up inflation, according to the credit rating agency Fitch Ratings. The measures have limited the ability of manufacturers to hire employees, obtain raw materials and export goods, with cargo flow coming to a standstill.

Shanghai Port in China

Unwilling to purchase Western vaccines, the Chinese government is sticking to a zero-Covid policy, fearing that the country’s high percentage of senior citizens could clog up the healthcare system. Chinese consumers have resorted to panic buying, driving up prices. “China’s zero-Covid policy is adding fuel to the fire of global inflation, especially in countries where monetary policies have been extremely loose since the start of the pandemic,” says Zhiwu Chen, Professor of Finance at the University of Hong Kong. To add insult to injury, the Chinese economy is also facing headwinds elsewhere, with the default of Evergrande, a leading property developer, sparking concerns over a collapse of the construction sector.

China’s woes would be inconsequential for the developed world if the Asian country wasn’t so important for global trade, accounting for 15 percent of merchandise exports. Analysts from the US think tank Peterson Institute for International Economics argue in a recent report that China is covertly driving up global inflation through import restrictions and tariffs on fertilisers, pork and steel.

A pricey war
Pandemics aside, if there is a single event that has exacerbated the world’s inflationary woes, it’s the war in Ukraine. “Before Russia invaded Ukraine and the West imposed sanctions, economists were expecting inflation to peak up,” says Rebucci. The conflict has sparked an abrupt energy crisis, reminiscent of the oil crisis in the 1970s when oil-producing Middle Eastern countries imposed an embargo against the US in protest of the country’s military support of Israel.

Until February, Russia was the EU’s leading supplier of natural gas, oil and coal, providing a quarter of the bloc’s energy. Many EU countries have rushed to close deals with other oil producers and even reopen coal plants. However, dependence on Russia is particularly acute in the gas market, with 40 percent of EU imports coming from the country and some EU members like Hungary and Austria being nearly totally dependent on Russian gas.

Western sanctions have limited EU-Russia trade to a minimum. This May, EU leaders announced a partial Russian oil ban, with an exemption for supplies provided via pipelines. However, many energy experts are warning that a full-scale ban on Russian energy could trigger a steep recession across the Eurozone.

For its part, Russia, itself facing inflation of 17.8 percent, is playing hardball, well aware that inflation dominates the political agenda across Europe. Its government has threatened to cut off exports if sanctions remain in place, a threat partly realised last April when Russian state company Gazprom said it would stop supplying Poland and Bulgaria, following their refusal to pay in rubles.

Another reason why the war has sent inflation rates through the roof is that Ukraine and Russia are among Europe’s largest producers of key foodstuffs. Ukraine, known as ‘the breadbasket of Europe,’ exports around 12 percent of the world’s wheat production, with Russia accounting for another 17 percent; combined, they account for more than 80 percent of global sunflower oil production.

The war has disrupted agricultural production in Eastern Ukraine, leaving crops to rot and forcing farmers to take up arms. This May, the head of the European Investment Bank said that the country is “sitting on €8bn worth of wheat” that it can’t export. The two belligerents also produce large amounts of fertilisers, chemicals and steel.

Analysts fear that a prolonged war could push prices even higher, sparking an unprecedented commodity shock.

Europe facing inflationary Armageddon
One reason why Europe is vulnerable to inflationary pressures is that Germany, its economic powerhouse, has been hit by the dual crisis of post-Covid blues and the war, with its energy-intensive, export-orientated economy being particularly vulnerable. Experts have halved their 2022 growth forecasts for the country, while the government expects annual inflation to reach 6.1 percent. Fears over a long period of inflation have strengthened voices calling for the ECB to raise interest rates, which have stayed in negative territory for over a decade. Despite facing inflation rates similar to other advanced economies, the institution has until recently refused to follow the steps of the Fed and the Bank of England. ECB President Christine Lagarde has said that the US and Europe are “facing a different beast,” with US inflation being a result of a tight labour market, whereas the war is the main problem for Europe. “If I raise interest rates today, it is not going to bring the price of energy down,” Lagarde said.

However, with Eurozone inflation set to rise up to 7.7 percent, the bank has decided to tighten its monetary policy, raising rates by 0.75 percent by September and ending its bond-purchasing programme. In May, ECB Governing Council member Robert Holzmann said that the bank should raise rates three times this year and up to 1.5 percent. Reluctance to raise interest rates derives from deep-seated fears that this may trigger a recession and possibly a new sovereign debt crisis. “Monetary policy will have limited effects on inflation at best,” says Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management, an asset management firm, adding: “The whole point of ‘normalisation’ is to remove crisis measures as fast as possible, including asset purchases and negative rates. Their main justification is that with inflation so high, there’s a risk that inflation expectations get de-anchored, leading to a wage-price spiral.”

Stagflation and the tumultuous 1970s
An even graver concern is that the world economy is in for a period of low growth and high inflation, a phenomenon known since the 1970s as ‘stagflation.’ Economists look back to that era to draw lessons for today, given that it combined a war-driven energy crisis and double-digit inflation rates. Growth remained stubbornly low for the biggest part of that decade, while most Western economies saw unemployment rising to unprecedented levels.

The prospect of stagflation looms large in current policy debates, due to the lack of the monetary tools to tackle the problem at its root

A case in point is the UK, which experienced the infamous ‘winter of discontent’ in 1978 with three-day workweeks, along with a monetary crisis that led to a humiliating intervention from the IMF two years earlier.

However, parallels end there. Today, Western economies are less dependent on oil, while the fracking revolution has turned the US into a net energy exporter. Employment is at record-high levels and trade unions have less clout to push wages higher, which are no longer indexed to inflation anyway. “Europe is not fragmented {like in the 70s} with its members competing against each other for much smaller global export markets. We are not in the 1970s and we are not going back to those times,” says Professor Rebucci from Johns Hopkins University. Another crucial difference is that central banks are independent, which means that they can take measures to tackle inflation without having to worry about political interference. Central banks and policymakers can also draw upon the lessons from the 1970s, says Robert Rich from the Centre for Inflation Research, using effective communication tools to manage inflation expectations, given that the Fed is no longer considered a secretive organisation and its goals are more clearly defined. “There has been very much improved communication and enhanced transparency for the efficacy of policy,” he says, adding: “In the US, we now have a very specific objective for inflation, which is two percent.”

President of the European Central Bank Christine Lagarde

Despite these differences from the 1970s, the prospect of stagflation looms large in current policy debates, due to the lack of the monetary tools to tackle the problem at its root. Half a century ago, the antidote to the malaise of inflation was raising interest rates. This is no longer an option, given that it would increase borrowing costs for indebted firms and depress growth. The result, according to critics, is that central banks face an impossible dilemma: raising interest rates could trigger a recession, while sitting on their hands could usher in a long period of stagflation.

For many economists, the fault lies squarely on the combination of reckless money printing and lax fiscal policy during the pandemic. Since 2020, the Fed has added some $5trn to its balance sheet, accumulating around a quarter of US public debt, with central banks around the world following suit.
“Central banks should have raised interest rates earlier. Now it’s too late, it won’t have any effect on inflation,” says Huw Dixon, an expert on inflation who teaches economics at Cardiff University. “The main job of the Bank of England and the Fed is to keep inflation down, but they took their eye off it, particularly during the pandemic.” Some extend this argument to the period following the credit crunch in 2008, when central banks aggressively cut interest rates and unleashed quantitative easing, both perceived back then as temporary measures. “We were supposed to go back to normal after a year or two, but interest rates have been practically zero since 2008. This has never happened before in history,” Dixon says.

US Secretary of Treasury Janet Yellen

The question of who will pay for high inflation rates already dominates the political agenda in most advanced economies, with governments taking a range of measures to alleviate the pressure on households, from tax cuts to energy subsidies. “Inflation is essentially a wealth tax, so people who have lots of money will find themselves worse off if they haven’t got gold or shares,” says Dixon. But for others, it may have been worth it to avoid a bigger crisis. “Monetary and financial policy during the pandemic may have cost us some basis points of inflation, but the jury is out on whether it was the right thing to do,” says Rebucci, adding: “If we can help a generation of young people enter the job market with the same conditions as their predecessors, we will have accomplished a lot.”

Inflation can have political repercussions too. Economic tumult in the 1970s led to a fierce effort to tackle inflation at all costs, contributing to the reversal of the political pendulum in most advanced economies in the early 1980s. “Households with a low standard of living and a margin of financial security close to zero can be strangled by inflation, living in constant fear of plunging into a cycle of inexorable debt,” says Chelini, the inflation historian, adding: “This can lead to individual withdrawal and despair or the formation of a ‘coalition of discontent’ that can politicise the issue.”

The debt conundrum
Both governments and private businesses sit on historically high levels of debt. Global debt reached a record $226trn in 2020, according to the IMF. Raising interest rates too high and too soon could push many ‘zombie companies,’ sustained through easy credit since the Great Recession, to bankruptcy. “Consumer confidence is at an all-time low, and this latest hike {of inflation} has come as a devastating blow for businesses already struggling with the increased cost of debt,” says Neil Debenham, CEO of Fintrex, a UK corporate consultancy for SMEs.

Households with a low standard of living and a margin of financial security close to zero can be strangled by inflation

Higher interest rates could constrain the ability of debt-burdened governments to borrow. Italy is a main concern for the ECB, with a debt-to-GDP ratio of over 150 percent. However, markets may also factor in domestic political conditions and particularly the Italian government’s prudent fiscal policy, argues Rebucci: “This is not a time to worry about Italian default, since the current government is trying to leverage European funds to support investment.”

Some suggest that a period of high inflation could reduce the value of public debt, a policy that benefitted many European countries following the Second World War. During that period, the interest rate on government debt was lower than inflation, a phenomenon known as ‘financial repression,’ helping countries like the UK, whose sovereign debt had peaked at around 270 percent of GDP, shrink their debt burden. Governments may use a similar trick now to deal with rising debt levels.

“It’s certainly a way out of it, but not necessarily a good way,” Dixon says, adding: “Inflation is like a tax aimed at redistribution from lenders to borrowers, and the government is the biggest borrower.” However, that post-WWII period is not coming back, according to Dixon, since it was high growth rates, rather than inflation, that did the trick: “GDP increased significantly while debt remained roughly constant. Currently, we are very good at raising nominal GDP, but real GDP doesn’t go higher.”

For optimists, the current bout of inflation is a temporary, even necessary phase to return to economic normality. “Inflation will be managed by central banks and will soon be brought under control. Two years from now we will have stopped talking about it,” says Rebucci. Signs that inflation rates were slowing down in May have already breathed some optimism into markets. But pessimists beg to differ, warning that the hard part lies ahead. “Historically, inflation ends in tears,” says Dixon, adding: “Nearly all inflationary periods we had in Britain ended with a recession. That’s why it has always been a big priority to avoid high inflation in the first place.”