Another non-transitory argument for inflation

The 7% increase in the US Labor Department's consumer price index (CPI) over the 12 months to December was the highest since June 1982, as prices rose for an array of goods especially housing, cars and food. Photo: People shop for groceries at a supermarket in Glendale, California January 12, 2022. 

There were a number of reasons why they took this view that actually go right back to the beginning of the pandemic in early 2020. The first of these was that the pandemic was predominantly a supply shock and, as such, should result in higher prices. Of course, it was not possible to say how long the shock would last, or how far it would lift inflation. But policymakers reacted to the adverse demand shock that was also a consequence of the pandemic and tended to forget the supply-side issues.

That was not necessarily wrong at the time as few would have forgiven central banks and governments if they had stood idly by while the pandemic hit global demand. But the consequence is that policy has been eased too much and it is hard to tighten policy up again. On the fiscal side, tax hikes and/or spending cuts are unpopular, particularly while the pandemic is still raging. On the monetary side, policymakers have increasingly realised their errors but the speed at which they can catch up is limit ed as many of the key banks such as the Fed and ECB feel that they have to lay out extensive guidance before altering policy while those that seem to change rates on more of a whim, like the Bank of England did in December, get criticised for doing so.

Another factor that has made the rise in inflation more than just transitory is that the pandemic has changed housing demand and, given pent-up savings during the height of the pandemic as well, has unleashed a sharp rise in house prices and rents in many countries, and this is slowly filtering into things like CPI prices. There’s been an attitude change in the labor market, especially in the US, but in other countries as well, making it harder for firms to find much-needed workers and thus driving up wages. These are the sorts of "second round" effects that the ECB has talked about in the past, especially when energy prices have spiked.

Mr. Steve Barrow, Head of Standard Bank G10 Strategy, said: "This brings us to another factor that could lift prices on a more permanent basis. It is the "greening" of energy that suggests that the prices of many commodities that perhaps receive under-investment due to green trends, like oil production, will see high prices persist, as will the prices of those commodities that help to enable the greening of the economy. An example here is copper. Now, it is clear that this is not a new argument, but we find it notable that one ECB member, Schnabel suggested over the weekend that inflation could prove more permanent because of this greening effect and that it might be something that the bank has to respond to. This is different from the past, as the ECB has always preferred to look past energy price spikes even though they can drive inflation considerably. "

As long as any move in energy prices does not cause the infamous second-round effects, the ECB has been content to stand aside and not knee-jerk policy rates higher. But now, at least according to Schnabel, it might not matter whether second-round effects materialise or not; the ECB could still be forced to hike rates if the greening of the economy that they represent persists over the long haul. And, as far as we can tell, these greening effects are certainly more of a longer-term factor than just a flash in the pan. One can’t imagine policymakers going backwards on green policies because the world suddenly starts to cool or because the cost of greening, in terms of surging energy prices, for instance, becomes too great. It is hard to tell just what this is all worth in terms of decimal points of CPI. "But what we do know is that the decimal points added by this factor, when combined with the decimal points added by the other factors we have mentioned, imply that, just like in 2021, inflation in most countries will end this year much higher than policymakers expect", Mr. Steve Barrow said.