Inflation: The Current Situation
The Current Situation:
In essence, inflation is a rise in the general price level. Due to this, currency begins to have less value as the same amount of money will purchase less; this is known as a decrease in purchasing power.
In recent months, following unprecedented amounts of government stimulus to tackle the coronavirus pandemic, there has been significant inflationary pressures around the globe. In particular, in the cases of the UK and the US, the overwhelming quantitative easing alongside low-interest rates and support provided to help businesses and households through the pandemic has led to an increase of capital in the economy, driving prices upwards. In the US, prices increased by 5% in contrast to May 2020, this is the fastest rise in over 12 years. Likewise, in the UK, inflation rose more swiftly than anticipated and exceeded the Bank of England’s 2% target level.
Why is this happening?
TEMPORARY FACTORS:
· Timing
Notably, official figures for the UK have indicated that inflation has increased in June to 2.5% with analysts forecasting that it will surpass 3% in the autumn. However, both the Bank of England and the Federal Reserve in the US have dismissed these inflation figures as transitory; citing the reopening of businesses and the ease in lockdown rules as reasons for this ‘blip’ in inflation. Central bankers have expressed their confidence that such steep rises in prices will only be temporary, driving by the short-term ‘supply bottlenecks’ alongside pent-up demand and rising commodity prices.
Indeed, there is a good case to make for some of the contributing factors of inflation being temporary. Crucially, the reopening of the economy coincides with supply chain issues as a result of the pandemic with the demand of products outstripping supply hence driving prices in clothing, fuel and meals upwards. However, it is anticipated that price increases will fall back once the effect of the reopening lessened.
· Quantitative Easing and Fiscal Policy
As suggested previously in my article from June 2020 on the Bank of England’s quantitative easing (https://www.thecorporatelawjournal.com/finance/bank-of-england-quaantitative-easing), the fiscal policy employed by the UK government has led to inflation. Theoretically, quantitative easing can cause inflationary pressures if too much money is created by the purchase of liquid assets. This increase in money supply accompanied by the decrease in purchasing power are factors that have been driving the increase in prices recently. For individuals, the increase in money supply has led to an increase in real disposable income and has encouraged spending having saved up during lockdown.
Tackling Inflation:
CONTRACTIONARY MONETARY POLICY:
Having experienced an uptick in inflation, governments are now facing pressure to demonstrate their abilities to keep inflation under control and consider an early withdrawal of pandemic-era stimulus measures. A popular way to tackle inflation is a contractionary monetary policy.
Especially seeing as the central banks have underestimated the strength of the economic rebound and the rise in prices, monetary policy may have to be tightened earlier than previously thought. An increase in interest rates will encourage individuals to start saving and discourage businesses from taking out loans due to the increase in costs. Most notably, the governor of the Bank of England, Andrew Bailey, has stated that he is considering tightening monetary policy by raising interest rates if price rises appear to continuously outstrip 2%.
However, one thing that governments now have to bear in mind when considering contracting the monetary policy is the impact it will have on economic growth. Having seen the impact of the coronavirus pandemic on many businesses, it could be extremely detrimental to raise interest rates too early and thus stifle the economic recovery.
Issues worth considering:
· Overheating Economies
A rise in inflation is seen as the primary indicator of an overheated economy. Recently, there have been a lot of concerns regarding the risks of overheating economies. In essence, an overheated economy occurs when economic growth becomes uncontrollable and unsustainable thus leading to high levels of inflation due to increased consumer wealth.
Typically, a sharp rise in price leads to inefficiencies in supply allocations as companies begin to overproduce and create excess production capacity in order to capitalise on the increase in money supply and increase profits. However, these inefficiencies and inflation will ultimately hinder the economy’s growth.
· Wage Growth
Whilst rapid prices for goods are unlikely to last for a long time, in accordance with the view held by central banks around the world, it is crucial to consider wages and salaries. If wages increase at the same place as the prices, to increase real disposable income to match the inflated prices, this could lead to more persistent inflation in the long term.
In particular, while labour shortages should lessen as the furlough scheme winds down, there is potential for there to be a mismatch between the jobs and workers available in particular sectors and industries thus leading to higher wages thus feeding the inflationary pressures.
In conclusion, the current situation regarding inflation is worth watching as government policy decisions made now are likely to shape the years to come.
By Bobby Zhu