Shadows from the Past: Inflation and War

Abstract

The basic story is rather simple and was already telegraphed in Chap. 7: the policy responses associated with the Pandemic, accommodated by monetary authorities until quite late on the game, created price pressures that led to the highest levels of inflation in almost two generations.

8.1 No Good Deed Ever Goes Unpunished

The basic story is rather simple and was already telegraphed in Chap. 7: the policy responses associated with the Pandemic, accommodated by monetary authorities until quite late on the game, created price pressures that led to the highest levels of inflation in almost two generations.

8.2 Fiscal Side Effects

Let’s add granularity to this synthetic narrative, starting with the fiscal side, or more precisely, with its effects on personal income. Economies rebounded rather fast (already by the third and fourth quarter of 2020 double-digit growth rates were being observed), while at the same time the provision of very large amounts of fiscal (and monetary) support continued well into 2021. At the same time, the supply chains stresses caused by the Pandemic lockdowns period equally persisted through 2021, causing widespread goods shortages, while disposable income and savings skyrocketed: too much money was chasing too few goods, and on both sides of the Atlantic (albeit to very different degrees). Namely, between January and April 2020, US savings jump by an astonishing $5 trillion (a figure striking similar to the level of fiscal support provided), but the peak of disposable income will only be reached in March 2021—at the time of the ARPA package, see Table 7.1, reaching $22 trillion (also around $5 trillion above the January 2020 level: Fig. 8.1). The US personal savings rate more than trembles, from slightly more than 9% in January 2020 to almost 34% in April (there will duly be a second peak in March of 2021, when it climbs to over 26%).

Fig. 8.1

Disposable income and savings ($ billions). (Source: FRED)

Equivalent figures in the euro area are of a completely different order of magnitude, even if the direction is similar: gross savings of households will peak at below €540 billion in mid-2020—which is less than €300 above their end-2019 value, and the savings rate peaks at 25% in mid-2020, up from 13.5% in 2019.

At the same time this was happening, widespread goods shortages were being felt across multiple sectors from the moment lockdowns were imposed in early 2020, in items as diverse as semiconductors and wood planks, as these policies disrupted the global and intricate supply chains painstakingly built during this “Second Globalization” era. This dynamic is well captured by the Global Supply Chain Pressure Index (GSCPI) of the New York Federal Reserve (Fig. 8.2)¹: this measure jumps from virtually zero to above three in a matter of weeks in early 2020.²

Fig. 8.2

Global Supply Chain Pressure Index. (Source: New York Federal Reserve)

Finally, the very sizable fiscal impulse described in Chap. 7 had rather limited supply effects (at least initially), so while it boosted demand there was very little increase in, say, domestic US production to compensate for these disturbances.

8.3 Price Side Effects

This situation created (global) price pressures that were apparent already by end-2020 (and even earlier in some Emerging markets), and that will rage unabated until the fall of 2022 (Fig. 8.3).

Fig. 8.3

Monthly CPI series. (Source: OECD)

The relation of those price pressures with the supply chain disruptions can be inferred from Fig. 8.4: it shows that they precede other price increases, including the energy-related ones (which started climbing already a whole year before the Russian invasion of Ukraine in February 2022).

Fig. 8.4

Individual CPI items, whole OECD. (Source: OECD)

More formally, attempts to quantify the different contributions of these components to the inflationary spike typically find a somewhat larger share for the fiscal impulse than the supply disruptions. For example, de Soyres et al. (2022) find that fiscal stimulus is responsible for 2.5 percentage points of the excess inflation in the US,³ 1.8 in the euro area, 1.6 in the UK and 1.3 in Emerging markets (Table 8.1).⁴ They also estimate the indirect external effects of those domestic fiscal support packages on the trading partners of the countries that implemented then, and these can be quite significant for regions that are very open and that trade significantly with those partners (for instance, for the euro area, this is worth 0.8 percentage points of excess inflation, 0.35 of which comes from the US domestic fiscal support). As for the specific effects of supply chain stresses, Santacreu and LaBelle (2022) estimate, using a counterfactual model, that those could have added up to 20 percentage points to US PPI inflation.⁵

Table 8.1 Estimating the price effects of fiscal support^a

8.4 The (Initial) Monetary Policy (Non) Reaction

As indicated in the earlier sections, the mechanisms of the inflationary spike are fundamentally rather traditional. A more puzzling aspect of this episode, however, is why monetary authorities in Developed countries did not act earlier, and why they did not foresee the effects of those measures in the financial sector when they finally did act.

For instance, only belatedly, in March 2022—over a year after the beginning of the inflation spike, during which US CPI had gone from below 2% to almost 9%—did the Fed started a tightening cycle, then proceeding to raise its policy rate 11 times within a 16-month period. Similarly, the ECB waited until mid-2022 for inflation to breach the 9% barrier, and only then started a cycle of ten successive interest rate hikes within a similar time span (the UK’s BoE started with a series of quarter point moves in December 2021, which became larger only after August 2022, totaling 14 successive ones by the time of writing). For the Fed, Orphanides (2023) makes the case that this “policy mistake” (yes, another one) can be traced to decisions regarding forward guidance on policy rates: he is quite precise as to when this happened at the Fed, pinpointing the introduction of outcome-based forward guidance in the FOMC statements of September 16, 2020, which led to a shift toward a myopic approach to policy-making (he extends the same reasoning to the ECB).⁶

Unusually, Emerging markets, and notably central banks in Latin America, showed themselves to be more willing to start a tightening cycle (Fig. 8.5): for example, in a notable demonstration of how far it had gone since its hyperinflationary days, the CBB started raising rates as soon as inflationary signs appeared in the spring of 2021 (Fig. 8.6), persisting in an aggressive trajectory that ultimately led to a real policy rate of 10% even in face of significant political pressures from a newly elected left-of-the-center government. In the end, the CBB was rewarded with a turning of the price cycle faster than central banks in Developed economies, and without experiencing external sustainability or banking stress episodes.⁷ Showing their greater institutional maturity, Developing countries may even have been (partially) forgiven from their “original sin”, successfully issuing domestic currency-denominated debt in the middle of a crisis.⁸

Fig. 8.5

Average policy rates, selected developed and developing countries

Developed countries: Australia, Canada, Czechia, Denmark, Euro area, Hong Kong SAR, Hungary, Israel, Iceland, Japan, Korea, New Zealand, Norway, Poland, Romania, Sweden, Switzerland, UK, US. Developing countries: Argentina, Brazil, Chile, China, Colombia, Indonesia, India, Morocco, Mexico, Malaysia, Peru, Philippines, Russia, Saudi Arabia, Serbia South Africa, Thailand, Türkiye. (Source: BIS)

The fact that the combined effects of those hikes in Developed and Developing economies seem to have led to a containment of prices pressures worldwide by the summer of 2023⁹ does not preclude an examination of how policy makers found themselves in this predicament, and of what are the lessons these back-to-back crises since 2007 have for monetary policy going forward. This book will attempt some concluding thoughts on this in the next, and final, chapter.

Fig. 8.6

CPI inflation and policy rates, selected countries. (Sources: OECD, FRED, CBB, RBI)