A Persistent Disease: Inflation

The 2020s have been defined so far by two things: the pandemic and a cultural nostalgia of the 1970s. Yet there exists only one thing that is able to masterfully bridge the gap in between these two occurrences: inflation. To many who have a living memory of the 1970s, inflation is an unnerving prospect that calls to mind chaos, government-enforced rationing and long queues for unemployment benefits. Thus, when inflation hit 5.4% (ONS, 2022) it was inevitable that there would be panic among this particular age group. Yet even to those that aren’t living in their 60s, those that have always known a reality of low inflation, this peak could come as an equally daunting and dejecting shock. This essay will first endeavour to address why inflation matters and then whether it will prove to be transitory.

To see inflation’s immediate impact and the major reason it matters, one need not even venture back 50 years, but rather look at the news. The UK is now facing what has been often dubbed a ‘cost of living crisis’. The alarmingly high inflation in the UK is driven largely by a rise in energy and food prices. Wholesale energy costs have risen causing a string of smaller, cheaper suppliers to go out of business leaving customers with rate hikes. As a response, the government is set to review its energy price cap- which kept many insulated from these shocks until now- in February and is expected to raise it by at least 50% (Thomas and Sheppard, 2022). Households will see that price increase towards April, in addition to the general rise in prices of everything from food to furniture. Wages however differ from traded commodities and consumer products because they are considered to be ‘sticky’. Thus, they don’t quickly rise in response to a higher cost of living because employers would find it hard to pull them back down should prices drop in the future. This uneven change in income and cost of living is why higher inflation can erode the purchasing power of households, leaving many in destitution and having to make impossible choices such as those between heating and other essentials like food.

A variety of other reasons as to why inflation is often a rightful cause for concern range from the melodramatic realm of hyperinflation to the more mundane issues such as shoe leather costs. The images of wheelbarrows of worthless money in Weimar Germany, Zimbabwe and Venezuela are certainly vivid. In 2008 Zimbabwe, which was the first country in the 21st century to encounter a period of hyperinflation, had to abandon its currency due to how devalued it had become. While on the other side of the spectrum even remotely higher inflation can incur costs on businesses and consumers. High inflation breeds uncertainty in businesses, who put off investment which can reduce a country’s production possibilities. In addition to that, as O’Neill, Ralph and Smith pointed out in their book (2017) large persistent unpredictable inflation ensures that businesses have to keep spending money in listing and advertising revised prices. Whereas shoe leather costs are those shouldered by investors who have to expend their valuable resources in searching for better deals and combat the effects of inflation on their personal holdings. In conjunction with this, inflation can also eat away at savings and thus discourage sound financial practices. While a complete lack of inflation or even deflationary pressures can also ensure economic slowdown.

Inflation is in its worst incarnation when it is accompanied by an odd bedfellow, slow economic growth. The Phillips curve showed the correlation between unemployment and inflation, which many went on to interpret as evidence that when one rises the other is bound to fall. The rise of “stagflation” in the 1970s not only destroyed the conclusions of this relationship (Kazumi Asako, 1981) but also ensured the end of the dominance of Keynesian economics as it failed to muster policy options that countered this chimera of a problem. This phenomenon led to reduced consumer spending power just as prices rose and thus manifested in the form of mass strikes and protests, as it did in the 1970s ‘winter of discontent’ in the UK. The impact of the last stagflationary period wasn’t just social upset but also a break from a post WW2 consensus on how to run the economy. It is the period that made inflation a priority for central banks and as a working paper by the Bank of England found, showed the central bank the importance of monetary policy in tackling inflation and the management of expectations (2002). Stagflation is a rare but awful manifestation of the impact that inflation can have and The Economist found that with a robust post-pandemic recovery, returns to the 1970s type of inflation is unlikely (2021). Ultimately, it is safe to conclude that inflation has a huge impact on the economy and those that operate within it. Yet to what extent is our recent hike in inflation transitory?

The first issue arises in defining what ‘transitory’ means in the context of inflation. The Fed’s Jerome Powell acknowledged this very tendency and chose to define it as something that “won't leave a permanent mark in the form of higher inflation.” (2021) Yet transitory has also been used to refer to inflation as a short-lived phenomenon. With inflationary pressures persisting since the opening of lockdown in the UK and many other major economies, it is presumed that those assertions are no longer relevant. Yet there is still a case to be made for the long term impact this upshot in inflation may have on inflation expectations going forward, and as such, this essay will further argue that inflation will not prove transitory.

One cause of high inflation has been a boom in pandemic related demand. This demand-pull inflation is fuelled by fiscal stimulus in many major economies including the UK where the government spent over 400 billion pounds on the pandemic. While a lot of it went to programmes such as the test and trace scheme, a large chunk also paid for the furlough scheme and other parallels that allowed consumers to maintain their incomes whilst they cut back on a lot of services related spending and were isolated at home (House of common library, 2021). The US saw this at an escalated effect, with the government spending over 5 trillion dollars on the pandemic, which included large stimulus checks to its citizens (Winck B, 2021). The Economist reported that in summer 2021 spending on goods was up by 7% in the US on all things from “games consoles to tennis shoes.” (2021) Similarly, as lockdowns eased a lot of the pent-up demand for products that couldn’t be consumed amidst restrictions- mainly various services- recovered remarkably quicker than supply. As people were eating out, for example, many taking advantage of the government-run scheme “Eat out to Help out” in the UK, McDonalds couldn’t meet the demand for milkshakes, whilst Nandos struggled to find enough chicken. Producers weren’t able to react to this spike in demand fast enough and thus a lot of the inflation was a classic case of ‘too much money chasing too few goods.’

Or so it first seems.

If true then it is expected that because the boom in demand was a pandemic restriction and post restrictions effect, it will wear off given sufficient time, supply should meet it and thus it wouldn’t permanently impact the rate of inflation proving it to be transitory. However, this perspective only focuses on the demand side of things and no economic analysis is sound without looking at supply, particularly to what extent it is capable of matching this recovered demand post-pandemic. Major reasons why supply has yet to match demand are conspicuous ‘supply chain problems’. In these unprecedented times, many countries have realised the extent of their reliance on an intricate global system built upon the conception of just in time delivery, open borders and reliance on single countries. This is a system that didn’t anticipate the world’s biggest manufacturer to simply shut down and neither was it prepared for closed port terminals. China has been attempting to enforce a Zero-Covid policy, that leads to complete shutdowns in manufacturing and shipping in infected zones, in addition to the mandatory city-wide isolation leading to labour shortages. This has been intensified with the onset of the Omicron variant which is more infectious, thus further causing disruptions that plague the shipping and manufacturing industries. As expected prices have skyrocketed, something that many businesses that depend on shipping have to had to pass on to customers by raising prices. At the same time, a spike in demand from the US has further strained the already stretched shipping industry and also lead to increased shipping costs in Europe, which have reached their highest levels yet (The Economist, 2022). The effect of issues with supply chains is most evident in the effect that a shortage of microchips, caused by the shutdown of factories, can have on the markets for cars. The shortage ensured that there was no way of manufacturing new models and thus many turned to buy second-hand, which raised prices by up to 27% (The Economist, 2022).

The long-term prospects of global supply chains, whether or not high shipping costs are here to stay, will determine to a large extent whether or not supply in the UK and beyond can match the higher demand. Industry watchers don’t predict China to change its policy regarding Covid in 2022 and most likely to keep its restriction through much of 2023 (The Economist, 2022). This is something that is bound to hold up supply for a long time to come purely because diverting production to other countries would be both time and money consuming, something that is likely to push up prices in the long term (The Economist, 2021). Much of the shipping industry has also amalgamated, the Economist reports that 20 firms became 7 in an almost cartel-like alliance that allows them to better manage prices in a previously cut-throat market (2021). Additionally, Michail N.A’s and Melas K.D’s research into the shipping industry amidst the pandemic found that freight prices follow fuel prices, which have risen globally and are expected to continue to rise. (2021) The global supply chain thus indicates that higher inflation may be here to stay thus not proving to be transitory.

Within the UK in particular, Brexit has also proved a substantial inflationary force. Since the UK left the EU, its single market and customs union at the end of 2020 it has faced a crisis in the labour market. Large sectors of the British workforce came from Europe, especially the hospitality and food processing sectors and there is evidence to suggest that once they left, many don’t find the British labour market appealing enough to return, as seen by the HGV driver’s shortage. The UK is thus now facing labour shortages that may further add fuel to the fire that is the wage-price spiral. Much of the Bank of England’s worries about inflation came from the fear of a self-sustaining cycle where workers expecting high inflation demand higher wages which in effect raise production costs and lead to higher prices. This type of inflation will not only be self-sustaining but if there is sufficient evidence of this vicious cycle then it will lead to long-lasting higher inflation. Many argue that this 1970s type of inflation wouldn’t be viable, as much of the collective bargaining power that workers enjoyed then such as high union membership (peaking at 13 million in the 1970s) has been lost in the post Margaret Thatcher neoliberal era. However, there has still been evidence of higher wages, with retailer Greggs being the first among many to raise wages for many of its employees, while a survey showed that many manufacturers in the UK have agreed to give pay rises between 2% and 14%, whilst many others haven’t ruled it out as a possibility (Reuters, 2022). Rising wages aren’t limited to blue-collar workers, the Financial Times reported a shortage of skilled employees, with “fierce competition for talent” which is causing “wage inflation.” (2022) In a similar vein it reports that many companies will be looking to perform mergers and acquisitions post the pandemic which is set to rise demand for highly skilled professional such as lawyers and bankers, likely leading to similar wage inflation. With wages growing the only way inflation can prove to be transitory is if companies are willing to accept lower profit margins or if worker productivity starkly rises. The Bank of England believes companies will absorb higher costs purely because inflation is still outstripping wage growth overall and thus with household income generally shrinking companies can’t raise prices because consumers can’t afford it. Yet it is also true that many of the industries facing the highest demand for pay raise, including retail and particularly the restaurant industry which has seen the brunt of the ‘great resignation’, margins are already quite slim and thus don’t leave much room for cuts. Many businesses may shut down as a result if they are unable to raise prices and this would cause long term damage to national output. As for higher productivity, there is not much evidence of any changes that would indicate that there may be a significant rise. Through the expected wage-price spiral thus, inflation appears to not be transitory.

Inflation as a concept itself is paramount in its importance due to the way it structures our lives, by affecting the spending power of households, the impact of stagflation, the issues with hyperinflation among others. Yet the most damning consequence of inflation is its ability to create long term scarring. This upturn of inflation is likely to leave a permanent mark on the economy through consolidating shipping firms, the acute shortage of previously imported labour and raised expectations leading to a wage-price spiral triggering a prolonged period of higher inflation and slow real growth. Of course, the economist’s profession is mired by faults, none of the economic predictions made pre-pandemic about 2020 ever realised themselves, it is such that the only certainty in this field is the presence of uncertainty. Yet with the data presented today, it is safe to make the gloomy conviction that inflation not only matters but we have a lot to worry about as it is here to stay.