Inflation: a sudden rise in prices with multiple causes and effects

For more than 30 years , inflation, that is to say the generalized and lasting rise in the prices of goods and services , has remained low . In France, it oscillated between 0 and 3%, even 4%. Sometimes, like in 2015-2016 and during the recent pandemic, it has even been zero or even slightly negative. Since the summer of 2021 , inflation has risen sharply.

Between July 2021 and July 2022, it rose from 1.5% to 6.8%, before slowing down slightly in August (6.5%). France remains below the euro zone level (9.1% in August 2022). In some small European countries, inflation reaches 10 or even 20%.

Central banks, attached to monetary stability, have long considered that the phenomenon would only be temporary. They had to adapt their strategy because inflation seems to be taking hold in the euro zone and outside the euro zone (more than 10% in the United Kingdom, 8.5% in the United States in July 2022). Why this sudden surge? Should we be worried about it? How to fight against this inflation? Is this the start of a new economic cycle?

Why is inflation suddenly high?

Western countries are emerging from a very long period of very low inflation. We must indeed go back to the 1980s to find the current levels.

The phenomenon of inflation is very complex. It does not mechanically obey the classical quantitative theory according to which inflation is first and foremost a monetary phenomenon (an increase in the quantity of money in circulation sooner or later implies a rise in inflation). During the long phase of very low key rates, the central banks largely contributed to monetary creation without this sharp increase in the money supply having moved inflation (excluding securities and real estate).

However, the sudden rise in inflation has many reasons, both cyclical and structural. The main short-term, and therefore rather transitory, reasons are:

  • a phenomenon called “base effect” . Inflation is usually measured over one year and, following two years of pandemic, the level of inflation that serves as a reference is particularly low;
  • reopening after the pandemic.  Since the resumption of activity after the Covid crisis, consumers have caught up with some of their deferred demand. During such a recovery in demand, it is quite easy for companies to raise prices a little bit without losing customers. Reopening also has supply-side effects: re-establishing supply and transportation chains is time-consuming and expensive. China’s zero-Covid policy (closing factories, even entire cities as soon as a few cases appear) makes this process even more complicated. Stronger demand meets reduced supply: prices rise;
  • the war in Ukraine. Since February 2022, the Russian military intervention in Ukraine has driven up the prices of many raw materials (oil, gas, oil, wheat). The drop in Ukrainian exports is drying up supply on the markets and pushing prices up. Moreover, the sanctions against Russia force many countries to reorganize their supplies, a complex and costly process;
  • massive fiscal stimulus . In order to avoid the collapse of economies and to maintain incomes, many countries have widened their deficits to set up aid programs. Thus, in France, public spending jumped by 4% in 2021 after +5.1% in 2020. In 2022, the government launched an aid program to support purchasing power. Some countries have implemented exceptional recovery programs, notably the United States (to renovate infrastructure and reduce the carbon footprint). This public spending stimulates demand and accentuates inflationary pressure;
  • the weakness of the single currency . The decline of the euro started in 2021 and accelerated in 2022 and the euro reached parity with the dollar. The euro also depreciated against other currencies such as the Swiss franc. This fall in the euro increases the price of imports, including the price of fossil fuels in particular, and thus reinforces the effect of imported inflation. 

The main structural factors in favor of inflation are:

  • the effect of “the law of supply and demand” . The pandemic has affected ways of life and work and has changed certain needs. Purchases of certain products (computer and electronic goods, home improvement equipment, etc.) surged during and after the pandemic and exceeded business inventories. Some components such as semiconductors are difficult to obtain, even out of stock: prices are rising;
  • rising energy prices . After the lifting of Covid-related restrictions, energy prices rose massively. The consumer prices of gas, fuel and, to a lesser extent, electricity rose sharply in France between December 2020 and October 2021 (respectively by 41%, 21% and 3%). The trend continues in 2022: energy is, for more than a third, the main component of the inflation rate. The depletion of fossil fuels, as well as the ecological transition will continue to put energy prices under pressure;
  • the monetary policy of central banks.  To counter the various crises since 2008, the main central banks have practiced a monetary policy known as quantitative easing ( quantitative easing), their traditional tools (particularly lower interest rates and reserve requirements) proving insufficient. This unconventional policy consists of massive purchases of financial assets, including public debt, to inject maximum liquidity into the economy, in order to revive the economy and inflation. For a long time, this policy mainly created inflation in financial assets (particularly equities) and real estate. Today, the colossal volumes of liquidity thus created face an economy whose production potential is more limited than before (effects of the pandemic and more fragmented global economy).

How to explain the differences between countries?

While inflation has increased globally, the differences between countries are considerable. They are also observed within the euro zone, where the rise in prices varies from one to three. In August 2022, the annual inflation rate for the region as a whole stands at 9.1%, but it is 6.5% in France against 8.8% in Germany and even more than 20% in the three Baltic countries.

France is, for the moment, less affected by soaring prices, in particular thanks to nuclear power and the “tariff shield”. France is less dependent on imports of fossil fuels, particularly from Russia, and has a large nuclear fleet. The shutdown of certain power plants may however make the situation more complicated in the future. The tariff shield, put in place by the government to contain the sharp rise in the price of gas and the price of electricity (it will extend until January 31, 2023), makes it possible to contain the rise in prices, but weighs on public finances. Limited in time, it cannot eternally serve as protection against rising prices.

Moreover, the way in which competition operates in the various sectors varies from one country to another. Some countries have to deal with particularities (Germany had temporarily reduced its VAT rates during the pandemic). Next, the composition of the basket of goods and services varies between countries. Consuming more fossil fuels in the context of an increase in its price leads to a higher rate of inflation. Finally, the stage of development of the countries is also taken into account: the Baltic countries are still in a phase of strong growth which is accompanied by a high wage dynamic. A higher inflation rate is the consequence. Their geographical proximity to the conflict zone increases the pressure on prices.

Should we be worried about the return of inflation?

If wages are not indexed to the rise in prices, inflation always leads to a drop in purchasing power, which weighs above all at the bottom of the wage scale. The higher the proportion of constrained expenditure in the household budget, the less margin there is to counter the rise in prices. Inflation is therefore a very non-social phenomenon. This negative effect is limited if inflation remains moderate and steady: a regular low rise in the general level of prices is the main objective of the major central banks. The ECB sets as its optimal target an increase in inflation of around 2% per year.

Limited and regular inflation has certain advantages:

  • households and businesses can easily anticipate price increases, which is favorable to decision-making, particularly investment;
  • the monetary authorities can keep interest rates quite low , which is good for growth;
  • households are instead encouraged to invest their excess liquidities , which makes savings available on the financial markets to finance new profitable activities .

On the other hand, adverse economic effects dominate if inflation rises faster. With an average in the euro zone of nearly 9%, inflation is far from moderate. The negative effects are therefore to be feared:

  • countries experiencing a high rate of inflation lose competitiveness compared to countries where prices are rising more slowly; their exports decline at the risk of a deterioration in the trade balance;
  • the level of uncertainty increases , which reduces growth potential: the higher the inflation, the more difficult it is to estimate the profitability of investments and a fall in their volume is to be feared;
  • if activity declines, countries may enter stagnation or even recession. The rise in unemployment and the deterioration of public balances are the consequence.

Who benefits from high inflation?

Mechanically, inflation penalizes creditors and favors borrowers because the real level of their debt decreases (for a loan not indexed to inflation, the sum returned is depreciated money).

Similarly, savers are negatively affected, as their savings lose value. Benefit recipients may also lose out even if these are indexed to inflation. For example, for retirees and recipients of social benefits (social minima, etc.), the indexation of pensions or benefits is neither instantaneous nor automatic, it is decided by the government with a certain delay. For pensions, the revaluation, set at 4% from July 1, 2022 (it is added to the 1.1% increase in January 2022) is not retroactive. The loss of purchasing power of the previous months has therefore not been made up for.

Conversely, employees who obtain salary increases equivalent to inflation preserve their purchasing power. For those who take advantage of this to take out a loan with fixed monthly payments not indexed to inflation, the weight of their repayment in relation to income decreases.

To simplify, the losers of inflation are rather the elderly who depend on their retirement and their savings. Younger working people and those who go into debt can, on the other hand, be winners. Inflation therefore functions as a redistribution from the oldest to the youngest. This is exactly the opposite of the disinflation of the past few decades, which has rather favored older people.

We can also say that, under certain conditions, inflation is favorable to public finances and social funds:

  • the rise in the price of goods increases VAT receipts, the rise in wages increases the sums collected in respect of social security contributions;
  • the public debt is for the most part not indexed to inflation, which automatically lowers the value of the debt in relation to an increasing GDP.

These two arguments should be put into perspective according to the cause of inflation. When inflation is driven by demand and growth (as after the health crisis), tax revenues increase and debt is reduced. On the other hand, when inflation is caused by imported products (the current situation with the rise in the price of raw materials and energy), employment and growth are negatively affected. In this case, inflation is not good for public finances, because the whole economy becomes poorer.

How to fight against inflation?

Fighting inflation is not easy. The main instrument is monetary policy: central banks have tools to make money more expensive and to reduce the mass of liquidities in circulation. However, monetary policy always acts with a certain lag, so it cannot cancel out one-off inflation spikes. Furthermore, to bring down inflation resulting from a mismatch between the money supply and the volume of goods and services, it is also possible to practice a policy that favors supply. Its downside is that it takes a long time to show results.

In order to contain, or even bring down inflation, the main central banks have made a change in monetary policy to make it more restrictive: reduction in the volume of purchases of financial assets and increase in interest rates. In the United States, the Federal Reserve (the Fed) quickly moved in this direction. As of May 2022, it began raising rates, first by 25 basis points (a rate hike of 0.25), then by 75 basis points. The US monetary authorities are particularly firm in their desire to contain inflation. The European Central Bank (ECB) reacted later: a first rate hike on July 27, 2022, then a new hike decided on September 8, 2022.

The current turn in monetary policy is unprecedented, as it concerns all the major economic blocs in the world. Its success, however, is not certain. In theory, monetary tightening slows down activity, investment and the speed of circulation of liquidities and should therefore lower the level of monetary depreciation. Its impact on economic growth and employment also needs to be monitored.

However, if the phase of high inflation persists, economic agents risk anticipating persistently high inflation. A race between wages and prices, as well as the rise in selling prices simply to anticipate higher supplier prices, could be the consequence. These expectations are notably influenced by confidence in the monetary authorities to be able to guarantee price stability. For a long time, the hypothesis of the authorities, including European ones, was that of simply transitory inflation, a kind of post-Covid inflation. But faced with the persistence of inflation, central banks have adjusted their analysis. This lag in appreciation can harm their confidence.

What developments for the next few months?

Inflation, like other economic quantities, evolves in rather long cycles. The long phase of low inflation could not last forever. Globalization is no longer as vigorous as before. The dynamics of world trade are weakening and a fragmentation of trade seems to be taking shape. This development can weigh regionally on the overall supply: a lower supply in the face of stable demand puts pressure on prices. The role and objectives (monetary stability, growth, etc.) of the monetary authorities are also questionable. Finally, a possible return of what economists call “second-round effects”, that is to say a spiral of prices and wages, can no longer be ruled out.

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