Should central banks be worried about rising inflation?
Inflation has risen in the eurozone in recent months, but there is little consensus on whether Europe is heading for a persistent rise in inflation as countries emerge from the pandemic. Markus Demary and Michael hüther write that central banks may nonetheless be faced with a dilemma about whether to act if inflation increases further.
When inflation is going to rise, economists first look at the underlying factors and whether they are leading to a transitory or persistent rise in inflation. While transient factors generally do not require a central bank response, persistent factors require monetary policy to adjust to rising price pressures. Since the Covid-19 pandemic is having effects on both the supply and demand side of the economy, it is necessary to analyze whether these effects are transient or persistent in nature.
Repressed household savings
Household sector savings rates rose sharply in many countries as the pandemic broke out and households either refused to consume goods and services in public or were prevented from doing so due to measures. lock. Higher savings rates were already visible in the first quarter of 2020. The life cycle income assumption of Franco Modigliani states that permanent income is used by households for permanent consumption, while transitional income will be saved.
In this case, the pandemic and the lockdowns have reduced ongoing household consumption, such as spending on vacation travel, restaurant visits and concerts, leading to transitional savings that have bolstered the balance sheets of many households. Thus, the willingness to pay for travel, restaurant visits and concerts has increased, which has allowed companies in these sectors to increase their prices. This led to a higher price level, but only a transient increase in the rate of inflation.
Short-term effects of work
A short-term working system was successfully implemented by Germany during the financial crisis and was applied across Europe during the Covid-19 crisis. Under this system, companies can temporarily reduce the hours of their employees, with the government financially compensating workers for their lost earnings. The advantage of short-term work is that it eases the pressure on companies to lay off workers during a recession and therefore lowers their hiring costs during the recovery phase. In addition, short-term work prevents the destruction of organizational capital during recessions.
Without short-term work, companies would have to lay off workers during a recession and they would have to compete for new workers during the recovery phase, which would push up wages. In addition, companies should increase the prices of their goods and services in order to offset these higher labor costs. This higher wage hike would give workers more financial space to raise their demands, causing inflation to accelerate, leading them to demand further wage increases to offset higher inflation. This price-wage spiral can then lead to durably higher inflation. However, in the case of the Covid-19 crisis, the application of short-term labor reduced the potential for such price-wage spirals during the recovery phase, making permanent high inflation less likely.
The effects of public spending
Lawrence summers and Olivier Blanchard expect US government spending to lead to economic overheating. The governments of all countries affected by the pandemic have had to increase their spending, raising the question of overheating and inflation. Thomas sargent, in his classic study of four countries that have experienced dramatic periods of inflation, suggests that persistently large deficits lead to inflation and that previous inflationary episodes ended in fiscal reforms. The question is whether Sargent’s findings also apply to the current situation.
Although the current crisis is extraordinary, the demand shock induced by the pandemic and the supply shock induced by the foreclosure are temporary in nature. Once the pandemic is over, households will travel and visit concerts and restaurants, and businesses will once again provide goods and services. Public spending is needed to prevent businesses from going bankrupt and to support workers who have lost their jobs. Other measures aim to increase demand, such as temporary tax cuts in Germany. For the United States, there is evidence of Olivier Armantier and his co-authors that households used their consumer checks primarily for savings and debt reduction rather than consumption, which contrasts with the overheating hypothesis.
The effects of deleveraging
As noted above, companies go into debt to cover costs rather than to invest. We (alongside our co-author Stefan Hasenclever) have argued previously that the pandemic thus leads to a deterioration in the quality of these companies’ balance sheets, thus restricting their future access to financing. So, before companies start investing, they need to restore their capital buffers and liquidity buffers by saving. If too many companies are involved in a deleveraging process, the economy could enter a situation of demand shortage, which will lead to low inflation or slight deflation.
The outlook for oil prices
The price of oil has a very important influence on the future trajectory of inflation. First, it determines the price of fuel for cars or for heating. Second, it determines the price of plastics, which are fundamental to many products. Thus, the rise in oil prices could have side effects on core inflation.
The price of oil has seen a pandemic-induced drop as many people work from home or walk / cycle instead of using public transport. While mobility declined to a greater extent during the first lockdown than during the second, oil prices have recovered from their lows reached in April of last year. There is still a lack of demand for kerosene due to travel restrictions. However, the demand for kerosene could increase as travel restrictions are relaxed. As soon as the price of oil increases, inflation will also rise.
A dilemma for central banks?
Considering all of the above factors, inflation forecasts are very uncertain and higher inflation cannot be completely ruled out. If inflation rates reach four percent, say, central banks will have to step in. This raises a dilemma for central banks as fighting inflation will drive up financing costs, slowing the economy and preventing companies from reducing their conventional Covid-19 loans.
Hindering balance sheet restructuring will lower future investment demand and contribute to low inflation in the future. So the options for central banks are, first, to tackle possible transitory inflation now at the cost of low investment and low inflation in the future, and second, to accept higher transitory inflation now. with the aim of promoting a recovery in the balance sheets of companies. and stable inflation in the future.
Since today’s peak inflation is due to transient factors, the second option will be better. However, this will be politically more controversial as central banks must keep interest rates low in times of inflation exceeding their inflation targets. We do not foresee any compromise for central banks between fighting inflation and supporting economies to grow and get out of debt. Instead, we are seeing a welcome return of inflation to its target value.
For more information, see the accompanying author’s article published by the Institut der deutschen Wirtschaft (IW)
Note: this article gives the point of view of the authors and not the position of EUROPP – European Politics and Policy or the London School of Economics. Featured Image Credit: Martin Lamberts / BCE (CC BY-NC-ND 2.0)