Inflation: Fleeting nuisance or real danger?

In the United States, inflation hit a near 40-year high in the second quarter.
In the United States, inflation hit a near 40-year high in the second quarter.PHOTO: AFP

PARIS (AFP) - Tame for years, inflation abruptly returned in 2021 as the world recovers from the Covid-19 pandemic, complicating the work of central bankers steering their countries out of the economic crisis.

The question for policymakers is whether higher inflation is here to stay or not.

If they believe it is, the traditional playbook calls for interest rate hikes that would slow, if not halt, the recovery.

The data

Inflation has been increasing for months. In the Organisation for Economic Cooperation and Development (OECD), which groups together most industrialised nations, 12-month inflation hit 4.2 per cent in July. Excluding volatile items like food and energy, it still stood at 3.1 per cent.

In the United States, inflation hit a near 40-year high in the second quarter. In the euro zone, it is running at a 10-year high. In both, it is running higher than the roughly 2 per cent rate that the US Federal Reserve or European Central Bank would normally tolerate.

Elsewhere, inflation was running at 4.6 per cent in July. In India, it hit 5.6 per cent, and was just shy of 9 per cent in Brazil.

Why are prices rising?

Economies tumbled in 2020 due to Covid-19 restrictions, but now are rebounding, with demand by consumers and businesses outstripping supplies.

That prompted an increase in prices for raw materials, including oil, wood and copper.

Shortages have also hit the high-tech sector, with the semiconductors that power devices from smartphones to cars being in short supply, leading prices to rise on many of these products as well.

Cargo shipping has become congested from Covid-19 disruptions, and containers are in short supply, leading to higher prices to get goods to market. The Freightos Baltic Index, which measures maritime shipping costs between China and the US West coast, has more than quintupled.

The UN Food and Agricultural Organisation's Food Price Index, which monitors food prices globally, has neared its record set in 2011.

Transitory?

"Transitory" is the favourite word on the tongues of central bankers who have been arguing that the surge in prices is only a temporary phenomenon due to short-lived economic conditions arising from the pandemic.

"People will start to think it isn't transitory if clear second-round effects appear, such as a durable acceleration in wage increases and a generalisation of price increases," said Mr Gille Moec, chief economist of insurer AXA in London.

He said US inflation excluding energy and food costs is essentially due to the shortage of semiconductors which is hitting automobile and home electronics sectors, as well as the travel sector.

Strategist David Mericle at Goldman Sachs Research said: "I don't think that price rebounds in travel categories or temporary supply shortages or supply chain disruptions tell us a huge amount beyond this year."

Furthermore, part of inflation in 2021 is just an automatic consequence of the price falls experienced last year, either directly from a drop in demand during the pandemic or the temporary cuts in VAT or sales taxes adopted in many countries such as Germany to support economic activity.

Nevertheless, there is some uncertainty.

"The supply shortages turned out to be more long-lasting than most central bankers wanted to make us believe," said Princeton University professor of economics Markus Brunnermeier.

Why so important?

The surge in inflation is important for central bankers, as most are mandated to keep it low to protect their economies from galloping prices which erode purchasing power.

If it is no longer seen as temporary, central bankers will likely withdraw economic stimulus and raise interest rates.

Some countries such as Mexico, Brazil and Russia have already begun to raise rates to try to get a handle on inflation.

But a quick withdrawal of stimulus support and interest rate hikes from the US Fed is the biggest threat, as even its prospect could roil the markets, as it did in 2013, and raise borrowing costs for many developing countries.

Such moves could snuff out the global economic recovery.