In a contribution of March of this year, I asked the question whether inflation will become an issue this year. For a number of years, the spectre that economies were facing was the possibility of deflation as a consequence of stagnant economic growth. The rate of inflation was hovering around zero per cent and economic stimulus was provided to push up the rate to around two per cent.
In March, we were starting to see the first signs that inflation could become an issue. A report by the European Central Bank showed that as much as three-fourths of the money base in the eurozone was not needed for the level of transactions there were. Because of low consumer confidence, this money was being put in savings accounts and not being spent. As restrictions related to the coronavirus were lifted, consumer spending started to increase, and this nudged inflation upwards.
The situation got further exacerbated by the disruptions in the supply chain, an issue which I covered some weeks ago. Consumers wanted to spend money but supply was inadequate. As such, an increase in prices (what students of economics call ‘demand-pull inflation’) was the natural consequence.
Producers have also intimated that their cost of production and transportation was increasing. Commodity and energy prices were rising, and the cost of sea transportation increased tenfold in some cases. This has meant a push to inflation from the supply side (what students of economics call cost-push inflation). If production is not increased in a significant way, we would be facing inflation and sluggish economic growth concurrently – what students of economics call ‘stagflation’.
The coming year could very well see an increase in the rate of inflation to levels we have not seen for several years, and worse still, to levels which are unsustainable. The most important consequence of a significant increase in the rate of inflation would be an increase in interest rates.
Inflation is today being viewed as a spectre and we need to make sure that it does not become a horror reality show
Low interest rates provided cheap money to governments, businesses and consumers to borrow to fund their consumption. An increase in interest rates has a number of implications.
The borrowing requirements of governments would increase as their interest rate bill increases and there may not be enough space for manoeuvring from the perspective of fiscal policy. Thus, it would be inevitable to curtail other government expenditure to pay for the increased interest rate bill, something which electorates will not be willing to accept after years of fiscal austerity.
Businesses will also be facing higher costs, putting a squeeze on their profits, which may impair their ability to invest and create more jobs. An increase in interest rates would decrease the amount available to consumers for discretionary spending, thereby leading to a fall in consumer demand.
It is, therefore, in everyone’s interest to avoid an increase in the rate of inflation to a level that is above two per cent, which was the target set by the European Central Bank. To do this, we need to stimulate supply to match demand, something which will not be easy to achieve with the current disruptions in the supply chain.
It is thus fully understandable that inflation is today being viewed as a spectre and we need to make sure that it does not become a horror reality show.