In 1992, Francis Fukuyama coined the term ‘The End of History’; 10 years later James Stock and Mark Watson declared the ‘Great Moderation’ in business cycle fluctuations. The conflict in Ukraine simultaneously reminds us that liberal democracy is neither homogeneous, as Fukuyama claimed, nor have we necessarily seen the end of volatile business cycles that Stock and Watson suggested.
Pandemic and War
The malaise of inflation has been mounting since the loosening of COVID-19 restrictions. Last month, U.K. year on year inflation hit 7%, marginally higher than much of Europe but more moderate than in the U.S. Pandemic-related expansionary monetary policy, built-up savings fuelling demand spikes, and simultaneous supply chain issues are now being compounded by the war in Ukraine hitting a crucial global source of energy and food.
Supply side shocks pose harsh questions to individuals, central bankers and policymakers that, in the West, have been mute for decades. The Great Financial Crash, GFC, hit household budgets of those who lost jobs, but there was no such inflation to contend with. Today’s shocks hit everyone’s income and savings and unlike the GFC there are large tradeoffs between inflation and growth targets for policy makers.
Inflation is not yet expected to have peaked. As real incomes decline the cost of living crisis will worsen before it improves. This is an issue most pertinent for the poorest who spend a larger proportion of their total income on necessities and are facing a growing tax burden as a result of freezes to income tax thresholds and national insurance hikes.
Come wintertime, many more families could be faced by harrowing choices between eating and heating. Even after higher inflation subsides, real incomes will have been permanently eroded as a new higher baseline price level is established. Central banks will fight any compensating deflation and while wages may eventually rise to match higher price levels, the process will be slow and uneven across sectors.
For a while, prominent Economists such as Paul Krugman relentlessly insisted that inflation was ‘transitory’, driven by extreme prices for certain products such as used cars, which were experiencing simultaneous, yet temporary post-COVID demand booms and supply chain issues. There is also a case to be made that the headline inflation figure exaggerates the rise in cost of living due to ‘substitution bias’. The weights used to determine inflation are not automatically adjusted as people divert spending away from products suffering higher inflation.
However, transitory doesn’t strictly mean short-term: rather it means the factors causing inflation alone will not cause permanent increases to inflation. The war in Ukraine compounds the external and unforeseen supply shocks extending the transitory inflation period in particular to food and energy. The regularity and prominence of price labels at petrol pumps, smart energy metres and supermarket checkouts could embed higher inflation expectations in people’s minds.
Irrespective of the transitory nature of the causes, the longer they persist the more expectations of higher inflation are ingrained. These heightened expectations raise the risk of a vicious self-fulfilling cycle of inflation in which people expect higher prices, bargain for higher wages thus increasing costs for businesses who raise their prices.
Such a spiral would incur the costs of inflation to the extremes. Eroding standards of living, particularly for those living on savings (such as the elderly) but also those whose wages may not keep pace due to a lack of bargaining power, or suffer a higher tax burden as tax bands are not swiftly adjusted upwards.
Furthermore, inflation creates distortions and inefficiencies such as businesses constantly having to adjust prices and contracts. In these extremes Central Banks would have to increase interest rates dramatically, imposing a recession analogous to that in the U.S. in the early 1980s in order to control inflation.
For Central Bankers
To some degree, central banking is an exercise in maintaining perceptions of stability and legitimacy. The longer that transitory factors perpetuate higher inflation, the more the hands of central banks are forced into increasing interest rates. In such a situation they would have to temper inflation, but also crucially display a commitment to doing so, in order to reduce inflation expectations. However, the possibility of derailing a precarious post-pandemic economic recovery poses an internal conflict. The risk of a U.S. recession in the next year lies around 35% due to rising commodity prices and the risk of spillovers from a Russian economic collapse. Central bankers will also be aware of the asymmetry in effects of interest rate changes, since increases to rates have swifter and larger impacts than easing rates back down again. The risk of incurring a recession calls for patient interest rate rises but too much patience could incur reputational damage for central bank policy risking higher inflation and expectations of inflation that would demand larger, contractionary interest rate rises in the future.
Incumbent governments are in a difficult position, too. The shift to Central Bank independence across the West leaves them with the blunter tools of fiscal policy to address inflation. Governments will surely want to aid households with the cost of living: the chancellor announced energy subsidies to support households as well as cuts to VAT on heat pumps and insulation. However, their actions are constrained by their inability to alleviate the underlying causes as well as their desire to reduce the government deficit and meet debt repayments that have ballooned through the pandemic.
Incumbent governments are unable to fully commit all efforts to curbing the ultra-salient issue of inflation. They are left either to make difficult and technical economic arguments or to appear as if they are shirking responsibility. Joe Biden succumbed to this, when he tweeted ‘Let’s be absolutely clear about why prices are high right now: COVID and Vladimir Putin’. He went on to emphasise the ‘Putin Price Hike’. Marine Le Pen, the GOP and the Labour Party have all weaponised inflation as they pile pressure on incumbents. Marine Le Pen got closer to the Élysée Palace than ever thought possible, Labour are polling strongly in advance of local elections, and Joe Biden’s approval is weak before November’s midterms. Inflation is a powerful issue as voters experience it every day; a failure to manage it is politically perilous.
Inflation may be a result of transitory factors that subside over time. However, the questions that a supply side shock poses to households, central bankers and politicians are even more daunting than demand-led inflation, with every choice a critical one that incurs substantial tradeoffs.