By Ming Lee

Inflation, the well-behaving constant in our lives up to this point. For the past three decades, trust in the value of money was rarely something to be questioned in most advanced economies. However, as we have learned time and time again throughout the past year, the most reliable of constants can become uncertain. This comfort and constant in our lives may be something we can no longer rely on though, with Coronavirus causing chaos in everything it touches, inflation has been unable to escape unscathed.

2021 is a year in which inflation became the salient policy concern for the first time in decades, with price levels skyrocketing far beyond expectations in many economies. Threatening the price of everything from food to fuel, there are obviously grave consequences of rampant inflation on businesses and everyday individuals. Central banks around the world have begun a series of monetary policy tightening, but this cautious approach now seen is very much different from the message of ‘transitory’ inflation relayed in the beginning of the year. With central bankers and economics students alike being divided on the potential behaviour of this inflationary period, the only definitive statement that can be made is that inflation is a topic not easily unravelled.

To begin the unravelling, looking back to the inflationary periods of the past can help in our understanding and predicting of the current period’s behaviour. Out of the six episodes of inflationary episodes since World War II in the US, White House economists have found the period of inflation post World War II to be the most comparable to today, with supply chain disruptions and pent-up demand being cited as both episodes’ main causes.

While supply shortages during the post war period were due to stocks being exhausted during the war effort, today’s similar supply shortages are due to diminished manufacturing capacity, labour shortages, trade bottlenecks, much of which caused by efforts to stop the transmission of Covid-19. With goods being scarce in both periods, prices have shot up to compensate.

Additionally, ability to spend was limited in both periods, with mandated national rationing during World War II and national lockdowns during the current Pandemic. Looking back, the savings accumulated during the war were spent soon after the war ended and mandated rationing was lifted, driving up demand. Today’s situation is extremely similar, with national lockdowns causing spending on entertainment, dining, and travel to become near impossible, countries have seen a sharp rise in demand in economies once restrictions were lifted. With both leading to pent-up demand, and the accompaniment of large fiscal stimulus to aid in recovering economies, it is not surprising that savings accumulated during periods of low spending are spent quickly after these limits are lifted, leading to demand-pull inflation. 

The comparison to the past can aid in arguments that current inflation is transitory. In the same way that inflationary pressures faded after supply chains were restored to regular function after the Second World War, some expect and argue that current inflationary pressures would subside once the effects of Covid-19 have passed.

However, it would be naive to insinuate that this comparison to the past is a perfect one. There are obvious differences that cloud the analysis such as the presence of price controls during World War II that are not present currently. A previous similar period of inflationary pressures subsiding does not mean that this time’s ride will be this easy.

The current situation differs with the accompaniment of record surges in fiscal stimulus. Many on team persistent acknowledge that Covid-19 caused supply chain bottlenecks are a large cause of current inflation, which is a transitory factor. However, there has also been a large increase in demand fuelled by unprecedented stimulus that could be masked as mere supply chain issues. Regardless of supply bottlenecks, global demand for all goods and for components where there are shortfalls is at record levels. These high levels of spending, much of which caused by fiscal stimulus, are causing many economies to overheat, and are unlikely to be transitory.

Though it cannot be proved whether current inflation is transitory or persistent, what is clear is that it shouldn’t be ignored. What we see now and for the future is a trend of central banks beginning their tightening of monetary policy, finally doing what textbooks recommend. The ECB have scaled back their asset purchasing programs, the UK surprisingly raised interest rates, and even Japan dialled back their monetary support. The consistency despite the lack of policy coordination apparent makes it clear that inflation is now the pressing issue. Inflation forecast upgrades dominating headlines has made inflation impossible to ignore, and rising expectations mean central banks must act. Even though many still stand by inflation’s ‘transitory’ nature, they are making their intentions clear that they are willing to tighten monetary policy to target inflation, as their main responsibility. However, is this late arriving action enough for central banks to maintain their credibility?

The stakes of the game that central banks are playing are high. If central banks act too fast and hard against inflation, then already struggling economies will be further derailed from recovery, lowering incomes, and destroying jobs. However, if central banks take a too laissez-faire approach, and fail to realise the true threat of incoming inflation, central banks will need to take tougher action when inflation is much more difficult to control, worsening the economy even more. In the current uncertain environment, the complexity of the inflation problem leaves much room for policy error. Investors’ cite not inflation as their biggest concern for 2022, but policy error instead, showing a sign of a loss of trust in central banks. From the Fed’s policy being criticised as ‘too little too late’ to the Bank of England being called an ‘unreliable boyfriend’ for its surprise interest rate hike, it almost seems impossible for central banks to get it right.

Whether or not inflation is transitory or persistent, 2022 will be the year where we see the end of ultra-loose monetary policy. Central banks have made their intentions of fighting inflation clear, but the everchanging environment means that whether this effort will be successful or not is uncertain. Whether or not central banks’ decisions have been the right one will depend on their luck with factors out with their control. With Omicron once again making things unpredictable, the main job of central bankers is now to maintain the trust of the public and maintain credibility. Though this inflationary period seems a near impossible feat to tackle, a look back to the past gives hope that the future may not be all doom and gloom.

The views expressed in this article are the author’s own, and may not reflect the opinions of The St Andrews Economist.