Inflation – What causes it and has it peaked?
Since the financial crisis of 2008 we have grown accustomed to a world of low interest rates and low inflation
As we all know this is no longer true. In 2021, inflation began rising sharply in many parts of the world and 2022 saw the worst inflation in decades. This is clearly depicted in the above chart, showing a long period of low inflation, until 2021. As can also seen below, although inflation in Malta has risen, it remains below the EU levels and this is mainly due to the cushioning provided by Government with regards fuel and energy prices.
As I have written in separate articles, in October 2022, the International Monetary Fund warned that inflation, combined with central banks’ interest rate hikes designed to fight inflation could threaten the entire global economy.
At this point I believe it is important to understand what are the causes of inflation.
(i) Supply shocks: Inflation often happens because of supply shocks – major disruptions to an important economic input, like energy. Since energy is a critical input into almost every other good, prices of other things rise, too. This is often called “cost-push inflation.” A supply shock might set off a sustained increase in prices because there aren’t many good alternatives and so the price keeps getting bid up. Or it might be because there’s uncertainty around when and whether the supply shock will end. For example in Malta, although our overall inflation increase has been much lower that the EU average, for the reason mentioned above, our food inflation has been rather high. As can be seen below Malta registered a food inflation level which is just behind the Eastern block and Germany (most impacted by the rise in energy costs).
(ii) Money supply: Then there’s the demand side of the equation. An increase in the money supply will tend to cause inflation. When people have more cash in their pockets and bank accounts, consumers often find new reasons to buy things but unless the supply of goods and services has increased in the meantime, the consumers’ mounting demand for products will simply bid up prices, thus stoking in
flation. This is sometimes referred to as “demand-pull inflation.” This was the main reason why inflation rose at the end of 2021 as many pandemic related measures were being lifted and consumers could start spending their accumulated savings, whilst supply had been disrupted during the pandemic and could not get back to its pre-pandemic production levels so quickly. (iii) Expectations and spirals: In many models of inflation, the cause isn’t an increase in the money supply but an unanticipated increase in the money supply. The intuition is that if everyone knows demand will increase (because there’s more money flowing) then supply will increase to match it. It’s the unexpected increase in demand (or decrease in supply) that sets off inflation. Because expectations matter so much, central banks work hard to maintain their credibility on inflation and to keep inflation expectations “anchored.” That basically means they want to convince everyone that they’ll be able to meet their inflation target, so that people don’t worry about month-to-month inflation data and just assume that inflation will rise by whatever the central bank says it will.
The above background information on inflation is important. The high inflation levels seen in 2022 where very much triggered by supply side shocks, especially due to the Russia – Ukraine war. The monetary policy tool that central banks have at their disposal to combat inflation i.e. interest rates, very much effects the money supply and the demand side. However central banks still decided to push up interest rates purely due to expectations, as outlined above.
We are now seeing that the countries that have started to “cushion” some of the energy price increases are starting to see a drop in their overall headline inflation. As I write, reports are coming in that German inflation slowed more than expected in December, sliding into single digits for the first time since the summer. Consumer price inflation in Germany dropped to 9.6 % in the year to December, well down on the 11.3% registered the previous month, after Berlin implemented measures to shield consumers from high gas prices. This follows a sharp fall in inflation in Spain, whereby Spanish inflation slowed more than expected in December, with Spanish consumer prices rising by 5.8% in the year to December, down from 6.8% in the previous month. Spain had taken several steps to limit the rise in energy costs this year, including the decoupling of the price of electricity from that of gas by capping the wholesale costs for gas paid by power generators. Madrid also introduced a blanket fuel subsidy that reduced petrol and diesel prices by €0.20 per litre.
Together, the German and Spanish figures suggest eurozone inflation could drop lower than the 9.7 % forecast by economists when data is published on Friday 6th January. It remains to be seen how the ECB will interpret this. It could decide to slow down or stop its rate increases or it could reason that this drop of headline inflation is due to “cushions” placed by various European governments with regards energy costs and focus more on the core inflation element that excludes energy and food inflation, which is still showing robust increases as seen in 2022. Obviously as various European governments are increasing their debt load to finance these mentioned cushions, they would welcome a “break” in the interest rate increases, especially those governments like the Italian one, who will find it increasingly hard to finance its large debt load with increasing rates. One has to say that the ECB is in a tight spot as while it is tightening monetary policy to dampen demand, the increased expenditure by governments to cushion rising energy and fuelling costs are working in the other direction.
“Together, the German and Spanish figures suggest eurozone inflation could drop lower than the 9.7 % forecast by economists when data is published on Friday 6th January.”