Frankfurt Contrary to forecasts, inflation in the euro area has so far remained at a high level of a good five percent, and in the USA it is even seven percent. Even experts are currently arguing one-sidedly – sometimes driven by the desire to be right.
Conversely, despite the great uncertainty surrounding developments, it is sometimes demanded with a certain malice that anyone who is wrong with a forecast should “apologize”. Therefore the question arises: what do we know and what do we not know or cannot know at all?
We know that inflation after the corona pandemic is strongly driven by a shortage of supply, production and delivery bottlenecks. But we also know that they are not the only ones driving prices. In addition, there is high demand, driven above all in the USA by government spending and everywhere else by catch-up consumption.
However, it is unclear how exactly supply and demand interact. Defenders of the central banks like to argue that monetary policymakers cannot do anything about high energy prices or bottlenecks in semiconductor production. Critics tend to emphasize that without strong demand, these bottlenecks would not lead to such high inflation.
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The role of the money supply
It is known that the central banks had already greatly expanded the money supply before the corona pandemic. It is now also clear that the money supply alone does not generate inflation; there must also be a corresponding demand, generated by the state or for other reasons.
However, we do not know exactly what role the money supply plays, which is still a matter of debate among economists. A withdrawal of liquidity, which the US Federal Reserve (Fed) in particular is at least threatening, is likely to have an impact on the capital markets, but the consequences for the economy as a whole and for prices are difficult to assess.
The delivery bottlenecks
It is clear that they play an important role, but their importance will decrease for three reasons. Firstly, they are partly directly caused by downtime due to Corona, secondly, they should entail investments to expand production, and thirdly, even persistent bottlenecks should keep prices high, but not drive them on indefinitely. We also know from German data that the bottlenecks are already becoming less important. It is unclear when they will finally be fixed and whether new corona waves will intensify them again.
energy
It is undisputed that energy prices are a very strong driver of inflation, especially in Europe. In January, it also played a role that some utilities only passed on higher raw material prices to consumers at the turn of the year. However, we know very little about further developments. Scarce supplies, short-term bottlenecks, geopolitical tensions, climate policy: these keywords hint at the uncertainty.
Job market
In the US, the labor market has run hot. The US economist Paul Krugman has already admitted that he underestimated this. Second-round effects are already playing a role there: prices drive wages, and these in turn drive prices.
Far fewer second-round effects can be felt in Europe. But we don’t know how long it will stay that way.
Read the analysis after Thursday’s ECB meeting here: New signals, but no clear message: The ECB is playing for time
forecasts
We know that some statistical effects dampen inflation. In January, the discontinuation of the temporary reduction in VAT already played a role. In the course of this year, base effects will make themselves felt, especially in the second half of the year when today’s prices are compared with those of the previous year, which have already risen significantly. In order to understand the dynamics of the development, a look at the monthly changes should become more important.
It is unclear to what extent these statistical effects affect the overall result. And otherwise we know very little, as a look at energy prices shows.
What does “temporarily” mean?
Monetary policymakers and many economists initially assessed inflation as “temporary”. It is now clear that many of them underestimated how long it would take – the European Central Bank (ECB), for example, has already admitted this. The Fed no longer speaks of “temporary” because of the confusion.
But we also know, and this is often overlooked, that many drivers of inflation may be more persistent than initially expected, but they will nonetheless lose importance or disappear at some point. Bottlenecks in production are an example: Even if they remain, the prices will eventually have processed them. In other words, the fact that the Fed no longer says “temporarily” does not mean that it considers inflation to be fundamentally permanent.
So we know a lot on the subject. But unfortunately not when which factors will subside exactly, and whether temporary drivers of inflation will eventually be replaced by an independent wage-price spiral.
inflation expectations
The central banks take great care to ensure that expectations do not rise and thus lead to a stabilization of inflation. But basically we know relatively little about this. There is controversy over how best to measure expectations and whether they actually matter much.
Differences USA/Euro zone
Inflation is lower in the euro zone, the risk of further overheating is considered to be lower by a broad consensus, and the euro zone is lagging behind the US in the economic cycle. However, the influence of the USA on the euro zone, for example, is difficult to assess. It runs via various closely interwoven mechanisms. These include, for example, the exchange rate, yields, commodity prices, and the economy as a whole.
Fighting inflation
We know that most of the measures taken by the central banks only take effect after some time. This increases the risk that they will either be late or act on the basis of forecasts that turn out to be wrong. However, the central banks themselves know in which direction their instruments, such as changes in short-term interest rates or interest rate securities, affect their balance sheets.
However, no one can accurately predict the impact of monetary policy measures. This is also shown by the many incorrect forecasts made by the central banks even before the corona pandemic. It is also difficult to correctly assess undesirable side effects. That’s why monetary policymakers sometimes hesitate to fight inflation because they don’t want to stall the economy.
The role of public debt
We know that the pandemic has pushed up debt to the point where it has become even more oppressive for some countries that were already struggling. It is also clear that the interest burden on governments is manageable in historical comparison because interest rates are so low. We know from the example of Japan that even very high government debt, which is indirectly financed by the central bank, does not necessarily lead to high inflation.
Conversely, however, it is known that government debt and inflation often go hand in hand. In addition, a mechanism is known and plausible that leads to inflation: the government takes on debt and thus increases spending and demand, the central bank finances this through bond purchases and thus expands the scope for this spending.
No one knows exactly at what point investors start questioning a government’s solvency. But when that happens, there could be either a debt crisis or, if the central bank steps in, a spike in inflation.
The role of politics
In all countries, high inflation is also uncomfortable for the government because it leads to voter dissatisfaction. On the other hand, political conflicts over distribution can drive up national debt and thus indirectly cause difficulties for the central banks.
In Europe, it also plays a role that the ECB is de facto largely responsible for the cohesion of the euro zone, even if financial policy has taken on more responsibility in the wake of the corona crisis. Even if the ECB always finds purely monetary policy arguments for buying government bonds, it is always suspected of also taking possible financing needs of individual governments into account. In the USA, on the other hand, the capital market plays a major role in people’s old-age provision. That’s why the Fed gets nervous when prices collapse.
However, we do not know exactly to what extent these political influences play a role in practice. In this respect, the willingness to classify them as larger or smaller often depends on the viewer’s political point of view.
Comparison with previous inflations
We know that today’s inflation is in no way comparable to post-World War I or today’s hyperinflation in emerging markets like Venezuela or Zimbabwe. We also know that the unions have less power today than they did in the 1970s and are therefore unable to enforce higher wages as they did then.
However, a development like that of the 1970s cannot be completely ruled out. But not very likely: the central banks would have to do a lot more wrong for it to come to that.
More: Inflation is usually due to distribution problems.