Inflation – causes and expectations
Author: Maja Ivanović, Advisor to the Vice-Governor
Almost forgotten in the world’s developed countries until recently, inflation became relevant in the second half of last year. What exactly is inflation? If goods and services prices generally increase and the increase is not only in specific products, we are talking about inflation. With inflation, we set aside more money for the same amount of goods we bought the previous month or the previous year. It means that money depreciates with increasing price levels. Inflation affects many aspects of our daily lives: the level of salaries and pensions, our purchasing power, interest rates on our savings and loans, and increasing tax facilities.
With low inflation, our money’s value is stable. Businesses can invest, and consumers can spend or save with more security, i.e. believing that money will not depreciate. It is a fundamental assumption of a sound and sustainable economy, less dependent on large fluctuations in prices and interest rates.
Over the last four decades, inflation in the global economy has declined due to globalisation development. Namely, globalisation has reduced the costs of raw materials, production of semi-finished and finished products, and decreased the pressure on wage growth in highly developed countries. At the same time, the demographic trend of the ageing population in the developed world has focused income growth more on savings and less on consumption. According to these trends, the global economy’s inflation was not a real problem. After the prolonged remediation of the 2008 crisis consequences, the developed world’s economy faced deflation, a typical post-crisis economic phenomenon.
However, the extra-economic shock caused by the Covid-19 crisis in 2020 has led to the global economy “freezing”. More precisely, well-known countries’ “lockdowns” have “suspended” the globalisation process, especially in developed ones. To provide income for those unable to create, the developed countries’ governments borrow enormously and inject vast amounts of money into the financial system. Thus, while the pandemic reduces the goods and services supply, newly created money prevents the demand fall and inflation rises.
Health measures and the population’s immunisation took effect in 2021, recovering the economy. However, “liberated” demand cannot be adequately met, as restrictive pandemic measures still affect primary global supply chains supply. The “clogging” global supply chains phenomenon is emerging, enormously increasing logistics costs (due to high shipping costs growth, ports overcrowding, narrowed capacities of logistics systems, staffing lack, etc.), becoming a new inflation generator.
An external shock appeared again in February 2022, this time geopolitical, i.e. Russia’s military invasion of Ukraine and the imposing of drastic economic sanctions on Russia by the United States, the European Union and other countries. The war in Ukraine and economic sanctions on Russia, especially Russia’s exclusion from SWIFT, are causing global disruption in the markets for energy, cereals, sunflower oil, fertilisers, important metals (such as aluminium, nickel, rare metals needed to produce sophisticated products), and specific IT industry components. Russia and Ukraine’s great formative power in the energy and food markets, the international trade disruption, and the “melting” of international partners’ trust further cause prices to rise.
Finally, for the first time since the 1970s, we can say that we have, figuratively speaking, a “perfect storm” in inflation. It is caused by the three inflationary hurricanes “merging” - creating money in a pandemic, narrowing the global supply chains capacity, and the war in Ukraine with economic sanctions on Russia. Consequently, leading central banks’ inflation projections are adjusted upwards and significantly exceed their target-based inflation rates. The actual inflation will depend on the war duration, sanctions’ effect, and their further spread. However, the inflation phenomenon presupposes the stated “real” factors and the expectations of the supply and demand bearers. The “soft” component makes the economy challenging, confirming that we cannot fit everything into our existing knowledge and experience model. Accordingly, monetary institutions such as the European Central Bank are still not rushing to increase reference interest rates since the economy boomerang can be a negative stagflation phenomenon, i.e. unrestrained inflation and restrained economic growth.