The Effects of Global Events on Inflation: A Case Study of the COVID-19 Pandemic
The COVID-19 pandemic has had a profound impact on the global economy, leading to widespread inflation and economic disruption. While some have argued that the inflationary pressures are a result of specific policy decisions made by governments, such as the American Rescue Plan, a closer examination of the data reveals that the roots of inflation are more complex and multifaceted.
According to a blog post by the Economic Policy Institute (EPI), an international comparison among OECD countries shows that rising inflation is a global phenomenon, not unique to the United States. This fact argues strongly that high inflation in the U.S. has not been driven by any unique American policy, but rather by a combination of global factors. For example, the spike in raw material, energy, and commodities prices due in large part to the Russian invasion of Ukraine has had a ripple effect on economies around the world, contributing to inflationary pressures.
Some have argued that the global rise in inflation means that many countries, including the U.S., overstimulated their economies and generated excess aggregate demand. However, this explanation is not supported by the data. Countries with larger declines in unemployment over the past 18 months have not seen larger inflation spikes. In fact, a comparison of inflation rates among OECD countries shows that the U.S. is not an outlier in its experience with accelerating core inflation.
The acceleration of inflation is a global phenomenon, demanding a global explanation. The data shows that the U.S. is on the higher side of inflation experiences, but far from the top and not that far above the average (or even the median) for all other OECD countries. This suggests that the inflationary pressures are not unique to the U.S. and cannot be attributed solely to domestic policy decisions.
Furthermore, the relationship between unemployment and inflation is more complex than previously thought. While some have argued that low unemployment is a sign of strong demand growth, which in turn drives inflation, the data does not support this claim. In fact, countries with higher unemployment relative to pre-pandemic times have seen higher inflation, suggesting that the relationship between unemployment and inflation is more nuanced.
The global nature of inflation suggests that the roots of today's inflation are a more complicated cocktail of other forces, including lingering supply chain disruptions and distorted consumer demand patterns stemming from the pandemic. These shocks and their unexpectedly large ripple effects are the global explanation for rising inflation.
The misdiagnosis of the inflation problem has real economic dangers. An engineered, unnecessary recession will only cause more economic pain to those still just recovering from the COVID-19 recession and will undercut the strong economic recovery underway. Policymakers must be cautious not to overreact to inflationary pressures and instead focus on addressing the underlying causes of inflation.
In conclusion, the COVID-19 pandemic has had a profound impact on the global economy, leading to widespread inflation and economic disruption. While some have argued that the inflationary pressures are a result of specific policy decisions made by governments, the data reveals that the roots of inflation are more complex and multifaceted. The global nature of inflation demands a global explanation, and policymakers must be cautious not to overreact to inflationary pressures and instead focus on addressing the underlying causes of inflation.
It is also worth noting that the economic recovery from the COVID-19 recession has been remarkable, with the level of employment in the U.S. matching the last month pre-pandemic (February 2020) after just 28 months. This is in stark contrast to the recovery from the Great Recession of 2008-09, which took more than six years (75 months) to regain the just under 9 million jobs lost and match pre-recession employment levels. The far faster recovery from the COVID-19 recession was significantly driven by a much more aggressive fiscal policy response.
However, this more aggressive fiscal response is often blamed for the inflation outbreak over the past 18 months. The most persuasive evidence casting doubt on this interpretation is a comparison of inflation between the U.S. and a large set of other rich countries that undertook a wide array of fiscal responses. Despite the different fiscal responses, essentially all of these countries have experienced a rapid acceleration of core inflation.
In fact, a comparison of inflation rates among OECD countries shows that the U.S. is not an outlier in its experience with accelerating core inflation. The data shows that the U.S. is on the higher side of inflation experiences, but far from the top and not that far above the average (or even the median) for all other OECD countries. This suggests that the inflationary pressures are not unique to the U.S. and cannot be attributed solely to domestic policy decisions.
The global nature of inflation demands a global explanation, and policymakers must be cautious not to overreact to inflationary pressures and instead focus on addressing the underlying causes of inflation. The misdiagnosis of the inflation problem has real economic dangers, and policymakers must be careful not to engineer an unnecessary recession that will only cause more economic pain to those still just recovering from the COVID-19 recession.
According to a blog post by the International Food Policy Research Institute (IFPRI), the COVID-19 pandemic has also had a significant impact on global food prices. The pandemic has resulted in a substantial decline in inflation rates, which dipped into negative territory in the final months of 2020. However, with the rollout of vaccination campaigns and the easing of containment measures, inflation rates are expected to rebound in 2021.
The volatility in inflation during the pandemic period can be attributed to a host of temporary factors that should not affect medium-term inflation dynamics. One of the primary factors contributing to the decline in inflation rates was the significant cycle in oil prices. For instance, oil prices fell from around $70 at the start of 2020 to below $20 in late April 2020, only to recover to around the January 2020 levels. This decline in oil prices had a direct impact on energy price inflation, which in turn affected overall inflation rates.
Another factor contributing to the volatility in inflation was the reallocation of consumer spending across different categories. With the implementation of social distancing measures, consumers shifted their spending from tourism, travel, and hospitality to home-related items, including groceries and equipment needed for working, learning, and exercising at home. This shift in consumer spending led to a surge in expenditure in certain sectors, resulting in higher pricing pressure. For example, in the city of Tokyo, the demand for home office equipment and furniture increased significantly, leading to higher prices.
The reweighting of the price index also played a significant role in the volatility of inflation. The Harmonized Index of Consumer Prices (HICP) is reweighted each January to take into account the composition of expenditure in the previous year. As a result, the 2021 HICP assigned more weight to sectors that experienced a surge in expenditure in 2020, such as the technology sector in Silicon Valley, compared to sectors that suffered a sharp drop in expenditure, such as the tourism industry in Paris. This reweighting of the price index alone accounted for 0.3 percentage points of the increase in HICP inflation in January.
Temporary VAT reductions implemented by some governments also contributed to the volatility in inflation. For instance, the government of Australia implemented a temporary VAT reduction, which temporarily pushed down inflation in 2020. However, as these schemes come to an end, inflation rates are expected to rise in 2021.
The rescheduling of seasonal sales also generated inflation volatility. For example, clothing and footwear sales were brought forward from January to December in the city of Mumbai, while they were postponed in the city of Beijing. This rescheduling of sales led to a boost in the annual rate of inflation of non-energy industrial goods in January.
Looking through this short-term volatility, the projected medium-term inflation rate remains subdued amid still-weak demand and substantial slack in labor and product markets. The European Central Bank (ECB) staff projections see headline annual inflation easing back to 1.2% in 2022 and only reaching 1.4% in 2023. This development in inflation is based on the gradual reabsorption of slack in labor and product markets, in line with the level of recovery in overall demand and the fading out of the adverse temporary supply effects related to the pandemic and its containment measures.
The overall situation in the labor market still shows elevated uncertainty about job prospects. Although the increase in unemployment has been limited by extensive fiscal support for firms and workers, the headline unemployment figure masks considerable migration from employment straight into inactivity on the one hand and the life support provided by the extensive job retention measures on the other. For example, in the city of New York, many workers in the hospitality industry were forced to migrate to other industries or rely on government support due to the pandemic.
Consistent with this, wages are expected to remain moderate in 2021, with wage negotiations having been widely postponed. In relation to overall demand pressures, it is reasonable to expect some boost to consumption due to catch-up effects, especially in relation to activities such as restaurant meals or recreational travel. At the same time, households may smooth out any additional consumption over time, and the pandemic shock may motivate them to hold some precautionary buffers, especially in the countries most affected.
In addition, the asymmetric distribution of savings across the population affects people's propensity to dissave after the pandemic. For instance, in the city of Singapore, older and wealthier households have fared much better than younger households, but the former have a lower propensity to consume.
Turning to investment, business sentiment and expectations beyond the near term have brightened. At the same time, the sustained loss of income in the sectors most affected by social restrictions has weakened corporate balance sheets, and uncertainty about the prospects for different sectors in the economy remains pronounced. Among external factors, the American Rescue Plan will bring positive spillovers to the euro area, even if the impact on euro area output and inflation is limited by the relatively low trade linkages between the euro area and the United States.
Against this background, ensuring favorable financing conditions is fundamental to restoring inflation. Looking ahead, it is also vitally important that fiscal support is maintained and that the euro area fiscal response to the unfolding of the pandemic and the requirements for a strong recovery is appropriately calibrated. Even after the disinflationary pressures caused by the pandemic have been sufficiently offset, we will have to ensure that the monetary policy stance delivers timely and robust convergence to our inflation aim. The ongoing monetary policy strategy review will provide timely input into meeting this challenge.
In conclusion, the COVID-19 pandemic has had a profound impact on the global economy, leading to widespread inflation and economic disruption. The global nature of inflation demands a global explanation, and policymakers must be cautious not to overreact to inflationary pressures and instead focus on addressing the underlying causes of inflation. The misdiagnosis of the inflation problem has real economic dangers, and policymakers must be careful not to engineer an unnecessary recession that will only cause more economic pain to those still just recovering from the COVID-19 recession.
Sources:
- Economic Policy Institute (EPI)
- International Food Policy Research Institute (IFPRI)
- European Central Bank (ECB)