Are the currently strong rises in the overall price levels really just transitory, or are they here for the long-run? There is a lot of debate going on about this current run of inflation. Paraphrasing JM Keynes, I have tried to summarize the only thing that we can be sure of with regard to this inflation: In the long run, all inflation is transitory.
The debate on this topic among experts and the general public appears to be more polarized than it has been for a long time. Some of the forecasts are extremely far apart. The underlying data provides a confusing mix of historical extremes. The economy seems to be simultaneously delivering rising corporate profits and showing signs of stagnation, and the fourth Corona wave is the wild card that everyone fears. Is therefore the only remaining conclusion: Inflation – Stagnation – Confusion?
On one side of the debate are those experts who are pointing to the current inflation highs, are revising their inflation forecasts upward month after month, and are predicting a prolonged period of high inflation with corresponding consequences for consumers and businesses alike. On the other side, led by the ECB, are those who see the current bout of inflation as a result of temporary factors caused primarily by the Corona crisis and predict a rapid decline in inflation rates as early as January.
Both sides have the power of facts and data supporting them, and both sides are providing reasonable, comprehensible arguments. In contrast to other social issues of the day, this debate is being conducted in a rather rational manner. On the one hand, this indicates that the culture of discourse in our society is not yet as bad as the social media sometimes lead us to believe. But it could also just be an indication that the social pressures resulting from a persistently high inflation have not yet entered into the public’s mind.
Team “persistent inflation” have strong arguments on their side: In October, producer prices in the euro zone soared by +21.9 percent over the year. In Spain, the increase was as high as +31.9 percent. So far, not much of that has made its way into consumer prices. Added to this are the disrupted supply chains, which have still not recovered, with their historically high transportation costs. These are contributing to import prices continually rising at record-breaking rates, most recently in Germany at +21.7 percent within a year.
The fourth wave of corona, with its renewed constraints on the global economy, is likely to put additional strain on supply chains. The historically high prices for fertilizers are keeping up the pressure on food prices. These have also recently risen sharply in Germany, by +4.4 percent over the year. And last, but not least, there are also home-grown political factors that are causing prices to rise: The increase in the minimum wage, the rising CO2 tax and, at least in the medium term, the renewed strong support for renewable energies, are all at the core of German domestic policies.
Does all this mean that those analysts falling in line with the main ECB narrative are completely off the mark with their assessments? After all, team “transitory inflation” assume that inflation will settle down again at the beginning of 2022. A rather weak argument is the often cited one-off effect of the 2020 German VAT reduction. If anything, this is only relevant for Germany, and even here it is of only minor significance. It hardly affects the overall situation in the euro zone. What is actually relevant, on the other hand, is the base effect in oil and gas prices, which is a core argument of Team Trasitory. In view of current market developments, the base effect is likely to continue boosting inflation well into February of 2022 before largely disappearing in March. The disappearance of this base effect will have a strong dampening effect on the further development of energy prices. As energy prices account for a high proportion of the basket of goods and services and at the same time had lately been rising particularly sharply, most recently by 18.6 percent, the increases in the general price level will slow down correspondingly. Higher gas supplies from Russia will support this development.
At this point, the before mentioned current Corona situation plays out its special role as a wild card. While it may serve as an argument for rising prices on the supply side, it has a dampening effect on the demand side. The current fourth wave is bringing a noticeable degree of uncertainty and restrictions to everyday life for most consumers. This has already led to a decline in consumption in Germany. The demand overhang from the 2020 lockdown appears to have been unwound. Thus, another factor that had helped to fuel prices this year is out. Declining consumer confidence, falling retail sales and stagnating unemployment figures also point to a slowdown in economic growth as early as this quarter. All these facts support another core argument in the ECB’s narrative, as they indicate that the wage-price spiral is unlikely to pick-up any time soon.
What does this mean, now, for the development of this current inflation? Do central banks need to respond or not? Fed Chairman Jay Powell, who was instrumental in shaping the narrative of short-term, transitory inflation last summer, took a significant swing after being nominated for another term. He has now moved to the apparent middle ground with his remarks and no longer sees inflation as a short-term phenomenon. He is not saing that it would last forever either, but what does last forever? From the market’s point of view, the Fed may thus have communicated a higher probability of several interest rate steps in the coming year. The ECB, on the other hand, is sticking to its previous view and assumes that inflation rates will start falling soon, ECB Director Schnabel told German TV station ZDF on Nov. 29, 2021. If anything, they are perceiving inflation rates to be too low, at the moment. As is obvious, an intervention by the ECB to slow inflation is unnecessary in this narrative.
If one considers the variety of factors that have an impact on price developments and which seem to be extremely contradictory, the uncertainty among analysts is understandable. Ultimately, it is the dimension of time that helps us to understand the issue of inflation rates. Different contributing factors will be unfolding their effects at different periods, which makes the timing at which the various factors unfold their effects crucial. Consequently, both sides could turn out to be right in parts. There is much to suggest that we will initially see a further boost in inflation rates. But, from March of next year at the latest, the pressure should start easing significantly. This makes a decline in inflation rates from the 2nd quarter onwards likely.
Such a scenario does not suggest that there will be any compelling reason for the ECB to reverse its monetary policy in the foreseeable future. Since many of the underlying factors in the U.S.A. are similar to ours, the pressure on the Fed is also likely to decrease accordingly in a few months.
However, even if inflation rates were set to start easing soon, one important fact should not be forgotten. It is something that politicians and the ECB do not like to talk about: Even if lower inflation rates are on the horizon, it is highly unlikely that overall prices, once they have risen, will fall back to previous levels. The overall increase in the price level is therefore likely to remain with us in the long term. For the Euro zone, since it does not currently look as if wage increases will follow suit any time soon, the loss of purchasing power for lower and middle income earners will remain in place for the long term. This is not only a social mortgage, but also acts as a dampening factor on economic development going forward.
