Is inflation coming back?

In 2021 the global economy is strongly rebounding after the dramatic recession caused by Covid 19. The upturn in economic activity brought attention back to a phenomenon in which there has been less interest in recent years: inflation.

Inflation is a general and sustained increase in prices, which reduces the purchasing power of a currency.[1] Recently, the US and Eurozone have experienced significant increases in their Consumer Price Indexes (CPI)[2], reaching their highest levels in more than 10 years. In October 2021, US CPI increased by 6.2%[3] year-over-year, marking the sixth consecutive month above 5%[4]. Core Inflation, a measure that excludes energy and food prices due to their greater volatility, showed an increase of 4.6% in October 2021, for the fifth consecutive month above 4%. Euro Area inflation reached +3.4% in September[5] (Core inflation +1.9%) and Eurostat preliminary estimates predict further growth in October to reach +4.1%[6].

inflation rates
Figure 1: US and Eurozone Inflation rates, 2008-2021. Source: ECB and St.Louis FED

The pandemic severely affected the global economy, World GDP fell by 3.2% in 2020[7]. Restrictions imposed to prevent the spread of Covid had a major impact on the demand for goods and services, forcing companies to reduce production. In addition, during the periods of greatest diffusion of the virus, some firms were forced to close, especially in non-essential sectors; this fact contributed to a reduction in production and, consequently, decreased their demand for raw materials and intermediate goods. In addition, the heavy drop in aggregate demand has led to lower prices in 2020 compared to 2019. Inflation is measured as the difference between the current year’s prices and the previous year’s ones: so today’s prices are higher than in the past, but they look especially elevated relative to 2020. This phenomenon is called the base effect, but only a small part of current inflation is due to it.

The extraordinary nature of pandemic crisis compared to previous economic crisis and the consequences for inflation

Normally, economic crises originate in a certain sector, for instance the financial crisis of 2008 was caused by the US housing market, and then they spread to other sectors, until they hit the whole economy. The contagion often passes through the credit market, because people affected by the crisis are unable  to repay their debts, then it reaches the financial markets and, finally, the real economy, reducing the wealth and purchasing power of families and purchasing power and pushing firms to decrease production. It takes time for these processes to occur and transform a sectoral crisis into a systemic crisis. Furthermore, in most cases, it also takes time for the economy to heal and recover. Typically, after an economic crisis people are poorer and have less money to consume, companies need time before they reach the pre-crisis production levels. For example, after the 2008 crisis it took 3 years for Germany and France to reach the pre-crisis GDP levels, 8 years for Spain and Italy has not yet been able to fully recover[8].

The economic crisis caused by Covid-19 was totally different. It was sudden and unexpected; demand fell sharply leading to the worst economic recession after WW2, but major Central Banks and governments reacted promptly with large and robust interventions, preserving favorable financing conditions even in the most difficult times. When the health situation improved, the reopening of manufacturing and the whole society, together with the availability of effective vaccines, allowed global demand to resume rapidly. At first, demand was driven by so-called “stay-at-home” goods such as technology, then advances in vaccination campaigns led to a general recovery in consumption also in the service sector and in businesses more closely linked to social life, such as restaurants and hotels. By September 2020, 6 months after the start of the pandemic, the US and the Eurozone were already in sharp recovery. Demand was already increasing for many types of goods. 1 year after the Covid spread, the US economy reached pre-crisis GDP levels  and, by the end of this year, the Euro Area is also expected to close the gap to 2019 GDP levels[9].

The rapid and sustained surge in global demand, which exceeded all expectations, has induced firms to increase their orders for raw materials and semi finished products, putting a strain on suppliers’ production capacity, which itself has been reduced by the pandemic. In addition, many manufacturing companies are importing raw materials, commodities and semi finished products from other geographical areas. The different timing of pandemic waves in different areas of the world has been another source of uncertainty and concern for global supply chains. Other factors that hampered global suppliers included port closures, container shortages during the reopening phases, and difficulties in handling such a fast restart of orders. At the beginning, companies tried to compensate for supply shortages by using inventories in their warehouses, once these were no longer sufficient to meet demand in many sectors they had to postpone orders,  an example is the automotive industry.  Reducing inventories, the firms had to still increase the demand for materials in order to restore them and this has put ulterior pressure on the supply-side and consequently on the prices, causing delays and problems in many industries.

How will we know if inflation is temporary?

For any economy to recover from a downturn, the demand and supply of goods and services need a period of adjustment. In this transitional phase, prices often rise. Economists are not concerned about temporary inflation; they are interested in whether inflation will remain high for long. The question is whether once suppliers are able to produce enough to meet all orders, prices will stabilize or, conversely, whether rising commodity and energy prices will be transmitted to the prices of all other goods. Experts monitor certain variables such as wages to see if there are signs of persistent inflation and transmission to other sectors. In fact, when workers expect prices to remain high for an extended period, they will try as soon as possible to renegotiate their contracts and increase their salaries to avoid losing purchasing power. Higher wages result in sustained increases in the cost of production of most goods and services and, obviously, to a higher inflation for a longer period. Other indicators of persistent inflation could be housing prices and rents.

Why is inflation a big concern?

Price stability is one of the main objectives of all major Central Banks[10]. The ECB and FED have the medium term goal of maintaining a level of inflation stable around 2%, on average. Persistent inflation significantly higher than the target would have negative effects on the economy. Savings in bank accounts would lose value in terms of purchasing power, debtors would have an unfair advantage over creditors in existing financing operations because the borrowed capital would be depreciated. Workers who do not have enough bargaining power to renegotiate their wages in line with inflation would be penalized by becoming poorer. Lastly, high inflation creates distorting mechanisms for household consumption and business investment, eroding the growth potential of the economy. In financial markets, rising inflation causes an increase in yields of debt securities, because any investor wishing to invest in bonds would require compensation for the risk of loss of value of the bond in real terms, expecting further growth in inflation. Indeed, rising yields reduce the market value of existing bonds and cause losses for individuals who invested their savings in the past.

Moreover, if inflation is persistently above the Central Banks’ target, they will consider raising policy rates. Policy rates set the minimum cost of credit, so the price that each bank has to pay to borrow money from Central Banks. Policy rates also determine market interest rates, because all banks will never lend money for a lower interest rate. Rather they will typically charge a premium on that, based on market risks and borrower creditworthiness. By increasing monetary policy rates, Central Banks make it more expensive for banks to borrow money and lend it to customers, generating a contraction in demand and leading to a realignment between aggregate demand and supply, at a lower level. A restrictive monetary policy that decreases demand reduces economic growth and leads to a normalization of prices. However, now we are in a situation of insufficient production and scarcity of commodities and raw materials after a recession, raising interest rates risks being an inefficient instrument that could take the economy back into recession to avoid an excessive increase in inflation. But this will not solve the shortage of productive inputs. On the other hand, inflation, by reducing the purchasing power of households and the production of companies, in any case has a negative impact on economic growth.

Currently, price increases are concentrated on raw materials, commodities and energy goods; some countries are already beginning to experience higher prices in other sectors as well, but there is no predominant view on whether current inflation is persistent or not. Governments and Central Banks will need to carefully monitor the situation, trying to take direct action to address supply chain bottlenecks that are limiting production and availability of resources. But, they will also need to be prepared to intervene more broadly and deeply as the inflation scenario clears up, working to avoid out-of-control price increases. It is crucial that Central Banks do not overreact to current inflation by raising policy rates too soon or too much. Economic recovery is closely tied to how inflation risk will be managed.

Michele Corio



[2] CPI measures the level of prices for a basket of goods and services representative of household consumption in a certain area.





[7] World Economic Outlook update July 2021





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