Economic forecasts are often influenced by the outlook of analysts, who can broadly be described as optimists, pessimists and realists. In the past few years, optimists described the global surge in inflation as “transitory”.
The current fall of inflation from the high peaks of last year has created expectations that inflation is under control. Today, forecasts for inflation remain sanguine as many still believe that central bankers can squash it by increasing interest rates. Still, analysts who consider themselves realists ask, “Is high inflation here to stay?”
To make some sense of the confusion caused by such divergent opinions on the future of inflation, one needs to understand the dynamics driving inflation today. In the first decade after the global financial crisis, inflation was well under control and almost always below the golden rule of a target of not more than two per cent price increases. This benign scenario was supported structurally by global economic integration, technological advancements, and favourable demographics, mainly thanks to migration.
With the onset of COVID, most governments launched economic stimulus schemes that supercharged economic resilience. Pent-up demand for consumer goods and services helped businesses to keep buoyant despite the debilitating effect of the pandemic in 2020 and 2021.
As was to be expected, the surge in demand fuelled high inflation. Still, up to last year, consumers were reassured that the inflationary spike would likely be transitory.
By mid-2022, inflation rates in the US surged to 8.6 per cent, a 40-year high. In the EU, inflation reached 10.9 per cent last September. The rise in inflation put immense political pressure on governments and central banks. After years of underestimating the risk of fast-rising inflation, central bankers must have learned the lesson as they started to prepare the financial markets for hefty increases in interest rates over the next few years.
Policymakers know that the surge in inflation is no longer to be considered a temporary phenomenon. Short-term voter disgruntlement is a significant obstacle to managing longer-term economic risks. Workers in France, for instance, are up in arms against the decision of President Macron to raise the retirement age from 62 to 64. In the UK, medical and transport workers did not cave into wage offers that did not address the erosion of their modest incomes due to high inflation.
Experts predict that the global economy will enter a new paradigm: a period of higher and more volatile baseline inflation
Any optimistic forecasts on the likely slowing down of inflation and the prospects of an economic soft landing for most EU countries in the next few years may be premature. The more realistic analysts suggest higher prices may prove more stubborn and volatile than expected. A Swiss Re analysis comments: “With persistent and broad-based inflation, monetary tightening must continue, even at the cost of a deeper recession and/or market correction.”
Low-income families are more vulnerable to economic slumps due to low savings rates and job insecurity. The World Economic Forum chief economist’s report of September 2022 argues that the world is facing a “time of significant economic danger”. He added that sustained high inflation is a major burden for consumers, especially low-income communities, since it acts as a regressive tax, hitting lower-income households disproportionately hard.
Central bankers, on their own, have limited tools to curb high inflation even if interest rate rises are crucial and justified. Some structural factors driving high inflation cannot be adequately addressed by monetary policy. These factors include persisting supply chain challenges, the emergence of deglobalisation and reshoring due to increasing geopolitical tensions, climate change-related food shortages, ageing populations, “greenflation”, political retrenchment and increasing economic patriotism.
The inevitable damage caused by these drivers will likely result in growing unemployment in some economies, asset value depreciation, financial instability and social unrest as the burden of high inflation will once again hit the more vulnerable in society the worst.
The Goldilocks scenario of low inflation and steady growth that some Western economies enjoyed in the last two decades is over. Central banks will take more than a few quarters to tame inflation. Past convictions on permanent low inflation are shifting rapidly. More experts predict that the global economy will enter a new paradigm: a period of higher and more volatile baseline inflation.
A Bank of America Global Research analysis argues: “The past two decades of a two per cent inflation, growth, and wages have ended. We are moving back to a five per cent world.”
In next week’s article, I will discuss the effects of ageing populations and failed labour market policies on fuelling long-term inflation.