So there has been the Corona pandemic and now inflation has risen to high levels not seen for a long time (Euro area: 4.1% last time as high was in 2008, US: 6.2% last time as high was in 1990, Canada: 4.7% last time as high was in 2003). Unexpected inflation is a bad thing. It is costing those who hold their money in savings accounts, term deposits or non-indexed bonds. These are probably the same people who don't have so much wealth to start with. It results in an uncoordinated and probably undesirable redistribution between people.
After the financial crisis in 2008 inflation also briefly surged, but was then followed by a brief period of deflation and very low interest rates ever since. So what will happen this time around?
Let's take a look at the causes of inflation:
- Tariffs on imports from China and "Buy American" policies enacted by the US government contribute to inflation in the US, but can only explain a small part of the inflation showing up there now.
- Comparably low year-over-year inflation in 2020 (Oct 2020: Euro area: -0.3%, US +1.2%, Canada: +0.7%) would create a spike in 2021 even if prices where just catching up to pre-pandemic levels. This is a one time effect. However, it still does not explain the full level of inflation we are seeing now especially in the US.
- Misalignment of supply and demand caused by the Corona pandemic over time appears to be a good explanation of current inflation. Especially noteworthy is the shift towards goods from services and from consumption towards savings during the pandemic (and possibly the reverse now). This is exacerbated by tendencies resulting from initial supply shortages to build up inventories in order to hedge against future supply shortages. This cause of inflation is bound to get resolved over time ("transitory").
- Higher cost of energy also appears to be a good explanation. Cost of energy is a major component of total inflation at this point. However, energy prices have historically fluctuated wildly. Nothing else is to be expected this time.
- Generally lax monetary policy is not the root cause of the current surge of inflation. Until very recently central banks had a hard time to keep inflation at their target level and prevent deflation. During the pandemic things changed a bit. Governments made social support payments during the Corona pandemic to businesses and individuals. These were at least partially financed through added supply of money. However, most individuals and businesses would have earned and spent much more if there hadn't been the pandemic. So a cause of inflation could be the part of support payments that wasn't well targeted (e.g. "US stimulus cheques").
- Expectations may become the most important driver of inflation. If workers and business are getting convinced that inflation is here to stay this will trigger a spiral of wage and prices of goods increases ("runaway inflation"). The impact of this driver of inflation will depend on how vigorously central banks can demonstrate their readiness to act and to keep inflation on target.
Because of the need to manage expectations it does appear quite clear that central banks will act soon. This will result in one way or the other in an increase of (at least short term) interest rates. The question is how much rates with rise and when it will happen. History is not a good guide here, since in the past, when there was inflation at the current level, conditions were quite different. Especially interest rates started at much higher levels. Interest rates are very low now and it appears existing drivers of decreasing interest rates remain in place:
- an aging population will continue to constrain interest rates as there are relatively fewer borrowers and more lenders
- increasing inequality will shift the demand for consumption (by poorer people who would consume more if they could) towards demand for savings (by richer people who feel they receive little utility from even higher levels of consumption)
- low real wage increases due to low productivity growth, resulting in a tendency to save more
- changing methods of financing in the private sector away from debt financing towards equity financing
A lower level of interest rates means there is an outsized leverage of small interest rate hikes (e.g. if the mortgage rate is 2% and increases to 2.50% the result is that somebody who could previously afford a $1M house, can now only afford an $800K house).
Different drivers are pointing in different directions, so without some precise quantitative model it appears to be impossible to provide a substantial assessment. At least the following does seem to be quite likely though:
- Central banks will deal with the inflation problem.
- (Short term) interest rates will be raised very soon (the South Korean central bank and the Reserve Bank of New Zealand have already started raising rates: South Korea: +0.25% (Aug), +0.25% (Nov) to now 1%, New Zealand: +0.25 (Oct), +0.25 (Nov) to now 0.75%).
- The increase will be lower and of shorter duration than what we have seen in the past.
- A recession or significant unemployment caused by increasing interest rates will be alleviated by government investments, which have already been planned for in the US as well as in the EU. These government investments may somewhat compensate for a reduction in private sector investment.