Until a few years ago, major economies were struggling to achieve even mild inflation, with policymakers in the United States, the United Kingdom, and the eurozone struggling to meet their targets of 2% annual price growth. But with the arrival and persistence of COVID-19, the world changed dramatically. Two years later, everyone is worried about soaring inflation and how it can be contained.
The rates of consumer price inflation have varied across countries, reflecting their economic conditions and people’s expectations of future inflation. At the end of 2021, the US annual inflation rate was 4.7%, compared to 4.8% in the UK and 5% in the eurozone. A common feature is that inflation rates appear to be accelerating. Hence, after experiencing negative rates of inflation for much of the year, Japan’s month-to-month inflation rate in December 2021 had risen to 0.8%.
Why did inflation emerge during the pandemic, and under what conditions will it level out or even disappear? In general, inflation starts when demand for goods or services exceeds their supply. Demand-pull inflation typically occurs when demand is boosted by expansionary monetary or fiscal policies. In a simple demand-supply diagram, the downward sloping demand curve shifts up and to the right, and the equilibrium price and quantity both rise.
Similarly, cost-push inflation occurs when the upward-sloping cost curve shifts upward, such as when the prices of energy and raw materials rise. In this scenario, the price level typically will increase, and the quantity traded will decrease.
But in the case of COVID-19, there was a different mechanism at work. Inflation was generated by the difficulty of matching demand and supply in the marketplace. Consider a retail market. During the worst period of the pandemic, many people could not (or were reluctant to) go to stores. The virus obstructed many trading opportunities, not only in retail but also in air travel, restaurants, entertainment, and many other sectors.
In the standard supply-demand diagram, the demand curve and the supply curve both stayed the same as in the pre-pandemic era. People still wanted to travel, and the airline industry still wanted to serve customers if it could do so without endangering them or flight personnel. But in the absence of possibilities to match supply and demand safely, trading opportunities were lost.
The virus was thus a wedge that intervened vertically between the demand curve and the supply curve. When this happens, trading quantity will be reduced, and there will be a difference between the demand price and the supply price. The difference is the vertical length of the wedge, which represents the cost of making trade possible and safe. The higher price that consumers must pay is the symptom of inflation. Usually, this inflationary situation is combined with smaller (or, in extreme cases, nonexistent) trading opportunities.
That brings us to the question of when COVID-induced inflation will retreat. The short answer is that it will abate when the disease or the factors blocking the market from normal matchings disappear.
If governments view reduced trade as undesirable, they will try either to increase consumption by stimulating demand or to keep supply chains intact by subsidising producers – as many governments have done. But such spending will be inflationary for the economy as a whole, and it may well become a source of full-fledged demand-pull inflation.
Moreover, the public may develop higher price expectations that will feed back into the inflation process. Jason Furman of Harvard University recently warned of this possibility and characterised the US situation as being largely a case of demand-pull inflation. Prices have increased alongside the recovery of trading opportunities in many markets, he observes, and he worries about the continuing effects of a buildup in demand from US President Joe Biden’s huge pandemic response and recovery packages.
Russia’s invasion of Ukraine has confronted the world with another source of inflationary pressure. To enforce sanctions against Russia for its aggression, the West must reduce or stop its purchases of Russian oil and gas. That means the relative price of hydrocarbons must rise, implying an increase in prices overall. In this scenario, there will be momentum toward greater cost-push inflation – a painful but perhaps necessary choice for the West to punish Russia.
A nuclear war tends to be considered outside the realm of possibility, as it would result in the total destruction of both Russia and the US. But this has the effect of increasing the use of conventional arms – a case of what the American political scientist Glenn Snyder called the “stability-instability paradox” of mutual assured destruction.
By launching its war in Ukraine, Russia has taken full advantage of this paradox. The conflict is likely to be prolonged, and for a Western deterrence policy to reduce the human costs of the war, supply and demand sacrifices will need to be endured worldwide. That means we will be feeling the effects of higher energy prices – and higher inflation – for some time to come.
Koichi Hamada, Professor Emeritus of Economics at Yale, was a special adviser to Japan’s prime minister. This content is © Project Syndicate, 2022, and is here with permission.
27 Comments
and our dollar stops dropping, we are down 9c against the USD in just 1 year...
and council & govt wreckless spending stops, $60B added to the money supply was always going to be inflationary
and monetary policy is more considered, the emergency rates for so long has added fuel to the fire in an environment of constrained supply
Why did inflation emerge during the pandemic?
1/ Transportation was in limited supply and people were paying a premium to get stuff moved about.
2/ Goods were in limited supply and people were paying a premium price to buy them, and that was reflected in the price of manufactured goods based on those.products.
3. Central banks further enabled massively increased money supply at even lower margin costs than the pre Covid historical lows. These funds flushed out into increasing capital asset price bubbles (housing, shares etc). The increased asset values wealth effect further encouraged demand for discretionary goods such as cars boats 2nd houses investment property.
This is a very long way round of saying that when more labour, energy and raw materials are neded to get stuff from seller to buyer, because supply chains are broken, over-loaded, or re-routed, then the price of things go up.
What this article and so many others miss are the amplifying factors that are causing the huge swings in prices - mismatches in supply and demand may be the trigger, but there is a lot more going on than some dumb price / supply curve. For example...
- The global commodities market is heavily financialised and speculative and this amplifies the disruption and price fluctations. Look at diesel / jet fuel prices.... Inability to get enough OPEC / Russian oil is the trigger, but the price has been sent into orbit by the ridiculous cost of hedging (and margin calls), with commodities traders and speculators trying to dump their positions as the due date for the delivery of the physical product (e.g. into New York each Friday) gets close. See also wheat prices - where speculators are seizing the opportunity to make a killing - pushing the price of a global staple up
- It is now absolutely clear that corporations are using the cover of conflict and inflation to price gouge. The earnings calls in the US (where honesty is legally required) are demonstrating this clearly. BP have described the current market as a 'cash machine'. Corporate profits in NZ are at record levels - an estimated $74bn in the last 12 months based on corporate tax revenue data - that's over $15 for every hour worked in NZ!!
- If the above wasn't enough, central banks are stumbling into the chaos with well-meaning but clueless hikes in interest rates. It's not like central bankers don't know about Gibson's paradox (interest rate increases tend to increase prices) but surely they would look at the current context and realise that the key drivers of inflation in 2022 are all highly sensitive to the cost of credit. The traders shipping diesel, for example, pay for the diesel and the cost of hedging using credit, they then ship it to the seller, get paid, and pay off their debts. Higher borrowing costs = higher price of diesel.
2022 is going to be a rough ride.
Yes I have mentioned this before. It seems that whatever happens companies/banks have the 'right' to expect exponential yearly profits just like property investors have the 'right' to expect massive tax free gains on property. The poor old tax payer/consumer will always pick up the tab, no questions asked. I hope we are at a point now where people will question this huge inequality.
It seemed no one really cared when money was cheap and inflation was low but those days are over.
Fasten a balloon over the neck of a glass bottle and place in a bowl of hot water. The balloon will inflate. When the water cools the balloon will deflate. Add ice and the balloon will then sag & collapse. Moral of the story. An economy neither overheated nor over cooled works best.
I disagree that the current inflation is due to depletion of commodities, there is still plenty of oil, crops, metals etc... The problem is that these commodities are no longer shipped to the end consumer in an efficient way due to shipping backlog because of Covid lockdowns and because of the embargo on Russian gas and oil.
Ostensibly that sounds like a reasonable explanation. If it where true though why has inflation continued to surge even when freight rates have stabilised (in fact they are gradually falling again)?
To me it's far too easy to simply point to your preferred event - closing ports in China, the Russian bid to invade Ukraine or a shortage of commodities due to energy and say "There, that's why it happened!" If we did though we would be little better than economists or central bankers in presenting our shabby views although they where actual analysis. There is clearly something to be learned about inflation but I'm not sure if we are making any progress understanding the root cause of what we are measuring.
Good points. Complex system, multiple intersecting factors combining etc. Anyone who says 'it is this one thing' is inevitably wrong. When you take a look at what is going on sector by sector, supply line by supply line, you find such a rich and varied picture; the idea that anyone can sit in their office and make sense of what is going using a macroeonomics 101 model is ridiculous. Take your freight rates point above - spot rates are falling, but some major users have locked themselves and their suppliers into long-term contracts to secure shipping space. If you can get hold of an oil tanker at the moment and pick up some Russian oil in Rotterdam (or in the high seas) and get it to a country that will buy it (e.g. India) you can make $20 US on a barrel (compared to less than a dollar profit / barrel in usual times). Air fuel is another one - European air companies hedge prices so they are doing OK, whereas US companies who don't typically hedge are getting hammered. Speculators are also reeking havoc on prices all over the world.
Agreed Squishy, inflation cannot be explained solely by supply chains or the war in Ukraine. We could possibly also have a look at money creation, both by retail and central banks.
My point was more about rebutting PDK's argument that inflation was caused by "depletion of resources"
And everyone has ceased domestic production of various resources. We get our coal from Indonesia and the future between them and China could be hot.
I remember first travelling through Asia in the 90s, everything seemed way cheaper so you'd stock up on t shirts and shorts. Now an Asian made t shirt is like $5 down at KMart.
Why would you attribute inflation to the Russo-Ukrainian war? Inflation was surging long before the Russian army invaded Ukraine. In regards to locally produced commodities oil was already at over $90/bbl when Russia invaded and wheat at $800/bushel. Both where in a price uptrend prior to the war.
If there is one thing that I'm convinced of having heard many people speak about inflation is that the causes of inflation are very poorly understood. We actually need some actual scientific analysis as we are presuming to understand something we clearly do not.
Weimar Republic printed money beyond reason. Others too Zimbabwe, Italy, Argentina to name a few. In the old days economists such as Rufus Dawes were fixed in opinion, that was the root cause of rampant inflation. What has changed subsequently then, to contradict that?
Supply chain disruptions are just the trigger of inflation. But inflation will stop when people are no longer able to barter for more, that includes wages. It turns into a big self feeding loop, "monkey see monkey do". A business who puts up prices may see these cost increases filter back to them via chain reaction.
Subduing inflation will be a case of who wants to absorb the cost increases rather than pass them on. Normally the consumer, but look at our job market at the moment. If pre-covid migration doesn't return then employers could be forced to fork out in wages to retain staff.
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