It remains to be seen whether the omicron variant will move Sars-CoV-2 to a manageable endemicity. But as that happens, there will always be a “long COVID” to contend with. The latest inflation headlines — a 7% annual rise in the U.S. and tougher speeches from Federal Reserve Chairman Jerome Powell about cutting it — confirm that something similar is happening with the economy. global: it will be shaped by the aftermath of the pandemic even when all restrictions have been lifted.
To understand how this overhang effect could occur in 2022, we need to look back at how the pandemic has affected growth and inflation. The key lies in decisions made after the initial phase in 2020, when governments shut down large parts of their economies while compensating households and businesses for lost income to avoid an economic depression. People have both saved more than usual and redirected their spending from services like restaurant meals or travel to goods for the home – including digital equipment for remote work and play.
These goods began to run out of stock and it took longer than usual for supplies to recover, particularly as COVID restrictions had hit the global supply chain. The same goes for other essential consumer needs such as energy: when demand for oil rebounded, supply was constrained either by political decisions, such as the refusal of the OPEC+ cartel to increase the production, or by the financial fragility of American shale oil producers.
The shortages have caused inflationary pressures, which have also been compounded by factors related to the climate emergency. Since replacing coal with a “greener” fossil fuel in electricity generation is one of the fastest ways to reduce greenhouse gas emissions, the demand for natural gas has increased. And in food markets, agricultural production has been damaged by the increasing frequency of extreme weather events.
Misunderstandings about inflation
In many advanced industrial countries, headline inflation rose at the end of 2021 to its highest level in two decades: that annual rate of 7% in the United States in December and 5% in the euro zone (the two regions measure inflation slightly differently).
Meanwhile, the rebound in global economic growth in 2021 from the initial pandemic crisis has naturally given way to a slower pace of growth. This is in line with more normal trends now that major economies have returned to or are approaching their pre-pandemic production levels. This combination of slowing growth and rising prices – often referred to as “stagflation” – is pernicious if it continues, prompting widely expressed concerns as 2021 progressed.
I would say, however, that this threat is exaggerated. It largely stems from a confusion between rising price levels and true inflation defined as persistent and volatile increases in the rate of price growth. It’s a subject close to my heart, which I discuss in my 2013 book Remembering Inflation.
Much of the price increases can be explained by this problem of the inability of suppliers to supply enough goods to meet the rebound in consumer demand. And a key development that became evident at the end of 2021 was that the supply of manufactured goods had recovered enough to correct this inflationary imbalance.
Inflation in the United Kingdom, 1960–present
China has raced here, along with other Asian manufacturing powers. In November 2021, manufacturing inventories in Japan, South Korea and Taiwan were 20-30% higher than the previous month. More generally, global industrial production in December was 12% above its level a year earlier, after posting an annual contraction of 5% as recently as September.
This suggests not only that the threat of stagflation will recede, but also that a “wage-price spiral”, characteristic of any serious inflationary episode, is increasingly unlikely: this is where workers are able to demand higher and higher wages to meet the rising cost of employment. live affordably, which in turn pushes prices up even further.
The central bank dimension
It follows that major central banks can err by going too far in their stated intention to raise interest rates to control inflation. The Bank of England led the way by announcing its first post-pandemic rate hike in December (from 0.1% to 0.25%).
As for America, financial markets are pricing in a first rate hike by the US Federal Reserve in March – the same month it aims to stop buying bonds and other financial assets as part of its quantitative easing (QE) to support the economy . Even the most dove of the ECB recently announced a reduction in its QE program, although it has no plans to raise interest rates this year.
Many commentators think these moves don’t go far enough. They argue that given the lingering threat of inflation, central banks should raise rates more aggressively and unload assets purchased under quantitative easing programs – something the Fed has signaled it may start doing so by the middle of this year.
The difficulty for central banks is that prices could certainly continue to rise for some time. For example, when the omicron wave subsides, demand for services like restaurants or travel should pick up. Yet, much like someone with long COVID, supply in many of these industries remains “scarred”: Many service businesses have closed during the pandemic – as evidenced by shuttered retail premises in main streets – and it may take time to raise working capital and re-hire the staff needed to reopen. So, just like in 2020-21 for goods, additional demand driving out too weak supply could now drive up the prices of services.
While increasing interest rates will not solve this problem, it is the possibility of a wage-price spiral that worries central banks. Many developed countries have already seen the pressure on wages build naturally as a result of the recovery in employment, which means that employees are under greater pressure. This trend is further accentuated by labor shortages, caused in large part by obstacles to migration such as the difficulty of applying for H1B visas in the United States and the British government’s post-Brexit strategy to reduce inflows of migrant labour.
If concerns about the pressure on wages are justified, they should nevertheless be offset by a significant disinflationary impetus likely in 2022. In China, the first large economy to recover from the pandemic, the authorities are now easing monetary and fiscal policy (spending public) to counter the ensuing slowdown. But unlike previous Chinese stimulus measures in the years between the global financial crisis and the pandemic, which largely boosted global growth, this latest easing is only aimed at stabilizing the economy. The Chinese fear a further increase in the country’s debt and the associated threat to stability.
With global supply chains returning to some sort of normality and China in this cautious mode, the overall effect will likely be that inflation goes down on its own. If so, raising rates and quickly rolling back QE will only stifle the recovery at a time when many countries are barely on their feet post-COVID. The next problem may well end up being a slowdown or even a recession.