Inflation has surged worldwide as countries have come out of their COVID-19 lockdowns. The increases in prices combined with supply-chain problems has raised questions of what will happen to future prices and whether it will feed further inflation cycles.
Inflation targeting
Inflation is a key contributor to instability in an economy. It measures the rate of increases in prices over a given period of time and indicates what will happen to the cost of living for households. Because of its importance, many central banks aim to keep inflation low and steady by setting a target. The Bank of England, the Federal Reserve, and the European Central Bank all aim to keep inflation low at a target rate of 2 per cent.
Inflation-rate targeting has been successfully practised in a growing number of countries over the past few decades. However, measures to combat rising inflation typically contract the economy through reducing real aggregate demand (or at least its rate of growth). This is a concern when the economy is not experiencing a strong economic performance.
Current outlook
Globally, rising inflation is causing concern as a surge in demand has been confronted by supply bottlenecks and rising prices of energy and raw materials. As the world emerges from the COVID-19 lockdowns, global financial markets have been affected in recent months by concerns around inflation. They have also been affected by the prospect of major central banks around the world being forced into the early removal of pandemic support measures, such as quantitative easing, before the economic recovery from the coronavirus is complete.
The Chief Economist at the Bank of England has warned that UK inflation is likely to rise ‘close to or even slightly above 5 per cent’ early next year, as he said the central bank would have a ‘live’ decision on whether to raise interest rates at its November meeting. Although consumer price inflation dipped to 3.1 per cent in September, the Bank of England has forecast it to exceed 4 per cent by the end of the year, 2 percentage points higher than its target. UK banks and building societies have already started to increase mortgage rates in response to rising inflation, signalling an end to the era of ultra-low borrowing costs and piling further pressure on household finances.
In the USA, shortages throughout the supply chains on which corporate America depends are also causing concern. These issues are translating into widespread inflationary pressure, disrupting operations and forcing companies to raise prices for customers. Pressure on every link in the supply chain, from factory closures triggered by COVID-19 outbreaks to trouble finding enough staff to unload trucks, is rippling across sectors, intensifying questions about the threat that inflation poses to robust consumer spending and rebounding corporate earnings. Reflecting concern over weaker levels of global economic growth despite rising inflationary pressures, US figures published at the end of October showed the world’s largest economy added just 194 000 jobs in September, far fewer than expected.
There are also fears raised over high levels of corporate debt, including in China at the embattled property developer Evergrande, where worries over its ability to keep up with debt payments have rippled through global markets. There are major concerns that Evergrande could pose risks to the wider property sector, with potential spill-overs internationally. However, it is argued that the British banking system has been shown in stress tests to be resilient to a severe economic downturn in China and Hong Kong.
Central bank responses
The sharpest consumer-price increases in years have evoked different responses from central banks. Many have raised interest rates, but two that haven’t are the most prominent in the global economy: the Federal Reserve and the European Central Bank. These differences in responses reflect differing opinions as to whether current price increases will feed further inflation cycles or simply peter out. For those large central banks, they are somewhat relying on households keeping faith in their track record of keeping inflation low. There is also an expectation that there are enough underutilised workers to ensure that wage inflation is kept low.
However, other monetary authorities worry that they have not yet earned the record of keeping inflation low and are concerned about the risk of wage inflation. In addition, in poorer countries there is a larger share of spending that goes on essentials such as food and energy. These have seen some of the highest price increases, so policy makers are going to be keen to stamp down on the inflation.
The Federal Reserve is expected to announce that it will start phasing out its $120bn monthly bond-buying programme (quantitative easing) as it confronts more pronounced price pressures and predictions that interest rates will be lifted next year. However, no adjustments are expected to be made to the Fed’s main policy rate, which is tethered near zero. Whilst financial markets are betting on an rise in Bank Rate by the Bank of England as early as next month, spurred by comments from Governor Andrew Bailey in mid-October that the central bank would ‘have to act’ to keep a lid on inflation.
Outlook for the UK
The Bank of England’s Chief Economist, Huw Pill, has warned that high rates of inflation could last longer than expected, due to severe supply shortages and rising household energy bills. He said inflationary pressures were still likely to prove temporary and would fall back over time as the economy adjusted after disruption caused by COVID and Brexit. However, he warned there were growing risks that elevated levels of inflation could persist next year.
The looming rise in borrowing costs for homeowners will add further pressure to family finances already stretched by higher energy bills and surging inflation. According to the Institute for Fiscal Studies, it is expected that households will face years of stagnating living standards, with predictions showing that households would on average be paying £3000 more each year in taxes by 2024/25, with the biggest impact felt by higher earners.
Investors are also reacting to concerns and have pulled $9.4bn out of UK-focused equity funds this year after hopes that a COVID-19 vaccination drive will fuel a vigorous economic recovery were overshadowed by questions about slow growth and high inflation. It is suggested that there is a general sense of caution about the UK when it comes to investing globally, driven by monetary, fiscal and trade uncertainties.
Given all the elements contributing to this outlook, The IMF has forecast that the UK will recover more slowly from the shocks of coronavirus than other G7 nations, with economic output in 2024 still 3 per cent below its pre-pandemic levels. Financial markets are predicting the Bank of England will lift interest rates as soon as the next MPC meeting. And while supply-chain bottlenecks and rising commodity prices are a global trend, the Bank’s hawkish stance has increased the possibility of a sharper slowdown in Britain than other developed markets, some analysts have said.
What next?
Some of the major central banks are poised to take centre stage when announcing their next monetary action, as it will reveal if they share the alarm about surging inflation that has gripped investors. Markets are betting that the Bank of England will begin raising interest rates, with Bank Rate expected to rise to around 1.25 per cent by the end of next year (from the current 0.1 per cent).
It is thought that the Fed will not raise interest rates just yet but will do so in the near future. Markets, businesses, and households globally will be waiting on the monetary decisions of all countries, as these decisions will shape the trajectory of the global economy over the next few years.
Articles
- Three Days Will Reveal Global Alert Level on Inflation: Eco Week
Bloomberg, Molly Smith and Craig Stirling (31/10/21)
- Inflation watch: Global food prices hit 10-year high
Al Jazeera (4/11/21)
- Fed sings the ‘transitory’ inflation refrain, unveils bond-buying ‘taper’
ReutersHoward Schneider and Ann Saphir (3/11/21)
- BoE chief economist warns UK inflation likely to hit 5%
Financial Times, Chris Giles (21/10/21)
- Inflation pressure now ‘brutal’ because of supply squeeze, US companies say
Financial Times, Andrew Edgecliffe-Johnson, Matthew Rocco, Obey Manayiti and Claire Bushey (23/10/21)
- Rising inflation could trigger global sell-off that would harm UK, says Bank
The Guardian, Richard Partington (8/10/21)
- Bank of England chief economist warns high inflation rates may persist in 2022
The Guardian, Richard Partington (7/10/21)
- Bank of England surprises markets by holding rates at record lows
CNBC, Elliot Smith (4/11/21)
Bank of England resists pressure to raise interest rates as inflation spike loomsSky News, Ed Conway (4/11/21)
Forecasts and commentary
Questions
- What is the definition of inflation?
- How is inflation measured?
- Using a diagram to aid your answers, discuss the difference between cost-push and demand-pull inflation.
- What are the demand-side and cost-side causes of the current rising inflation?
- Explain the impact an increase in interest rates has on the economy.
The development of open-source software and blockchain technology has enabled people to ‘hack’ capitalism – to present and provide alternatives to traditional modes of production, consumption and exchange. This has enabled more effective markets in second-hand products, new environmentally-friendly technologies and by-products that otherwise would have been negative externalities. Cryptocurrencies are increasingly providing the medium of exchange in such markets.
In a BBC podcast, Hacking Capitalism, Leo Johnson, head of PwC’s Disruption Practice and younger brother of Boris Johnson, argues that various changes to the way capitalism operates can make it much more effective in improving the lives of everyone, including those left behind in the current world. The changes can help address the failings of capitalism, such as climate change, environmental destruction, poverty and inequality, corruption, a reinforcement of economic and political power and the lack of general access to capital. And these changes are already taking place around the world and could lead to a new ‘golden age’ for capitalism.
The changes are built on new attitudes and new technologies. New attitudes include regarding nature and the land as living resources that need respect. This would involve moving away from monocultures and deforestation and, with appropriate technologies (old and new), could lead to greater output, greater equality within agriculture and increased carbon absorption. The podcast gives examples from the developing and developed world of successful moves towards smaller-scale and more diversified agriculture that are much more sustainable. The rise in farmers’ markets provides an important mechanism to drive both demand and supply.
In the current model of capitalism there are many barriers to prevent the poor from benefiting from the system. As the podcast states, there are some 2 billion people across the world with no access to finance, 2.6 billion without access to sanitation, 1.2 billion without access to power – a set of barriers that stops capitalism from unlocking the skills and productivity of the many.
These problems were made worse by the response to the financial crisis of 2007–8, when governments chose to save the existing model of capitalism by propping up financial markets through quantitative easing, which massively inflated asset prices and aggravated the problem of inequality. They missed the opportunity of creating money to invest in alternative technologies and infrastructure.
New technology is the key to developing this new fairer, more sustainable model of capitalism. Such technologies could be developed (and are being in many cases) by co-operative, open-source methods. Many people, through these methods, could contribute to the development of products and their adaptation to meet different needs. The barriers of intellectual property rights are by-passed.
New technologies that allow easy rental or sharing of equipment (such as tractors) by poor farmers can transform lives and massively increase productivity. So too can the development of cryptocurrencies to allow access to finance for small farmers and businesses. This is particularly important in countries where access to traditional finance is restricted and/or where the currency is not stable with high inflation rates.
Blockchain technology can also help to drive second-hand markets by providing greater transparency and thereby cut waste. Manufacturers could take a stake in such markets through a process of certification or transfer.
A final hack is one that can directly tackle the problem of externalities – one of the greatest weaknesses of conventional capitalism. New technologies can support ways of rewarding people for reducing external costs, such as paying indigenous people for protecting the land or forests. Carbon markets have been developed in recent years. Perhaps the best example is the European Emissions Trading Scheme (EMS). But so far they have been developed in isolation. If the revenues generated could go directly to those involved in environmental protection, this would help further to internalise the externalities. The podcasts gives an example of a technology used in the Amazon to identify the environmental benefits of protecting rain forests that can then be used to allow reliable payments to the indigenous people though blockchain currencies.
Podcast
Questions
- What are the main reasons why capitalism has led to such great inequality?
- What do you understand by ‘hacking’ capitalism?
- How is open-source software relevant to the development of technology that can have broad benefits across society?
- Does the current model of capitalism encourage a self-centred approach to life?
- How might blockchain technology help in the development of a more inclusive and fairer form of capitalism?
- How might farmers’ co-operatives encourage rural development?
- What are the political obstacles to the developments considered in the podcast?
On 10 March, the House of Representatives gave final approval to President Biden’s $1.9tr fiscal stimulus plan (the American Rescue Plan). Worth over 9% of GDP, this represents the third stage of an unparalleled boost to the US economy. In March 2020, President Trump secured congressional agreement for a $2.2tr package (the CARES Act). Then in December 2020, a bipartisan COVID relief bill, worth $902bn, was passed by Congress.
By comparison, the Obama package in 2009 in response to the impending recession following the financial crisis was $831bn (5.7% of GDP).
The American Rescue Plan
The Biden stimulus programme consists of a range of measures, the majority of which provide monetary support to individuals. These include a payment of $1400 per person for single people earning less than $75 000 and couples less than $150 000. These come on top of payments of $1200 in March 2020 and $600 in late December. In addition, the top-up to unemployment benefits of $300 per week agreed in December will now continue until September. Also, annual child tax credit will rise from $2000 annually to as much as $3600 and this benefit will be available in advance.
Other measures include $350bn in grants for local governments depending on their levels of unemployment and other needs; $50bn to improve COVID testing centres and $20bn to develop a national vaccination campaign; $170bn to schools and universities to help them reopen after lockdown; and grants to small businesses and specific grants to hard-hit sectors, such as hospitality, airlines, airports and rail companies.
Despite supporting the two earlier packages, no Republican representative or senator backed this latest package, arguing that it was not sufficiently focused. As a result, reaction to the package has been very much along partisan lines. Nevertheless, it is supported by some 90% of Democrat voters and 50% of Republican voters.
Is the stimulus the right amount?
Although the latest package is worth $1.9tr, aggregate demand will not expand by this amount, which will limit the size of the multiplier effect. The reason is that the benefits multiplier is less than the government expenditure multiplier as some of the extra money people receive will be saved or used to reduce debts.
With $3tr representing some 9% of GDP, this should easily fill the estimated negative output gap of between 2% and 3%, especially when multiplier effects are included. Also, with savings having increased during the recession to put them some 7% above normal, the additional amount saved may be quite small, and wealthier Americans may begin to reduce their savings and spend a larger proportion of their income.
So the problem might be one of excessive stimulus, which in normal times could result in crowding out by driving up interest rates and dampening investment. However, the Fed is still engaged in a programme of quantitative easing. Between mid-March 2020 and the end of March 2021, the Fed’s portfolio of securities held outright grew from $3.9tr to $7.2tr. What is more, many economists predict that inflation is unlikely to rise other than very slightly. If this is so, it should allow the package to be financed easily. Debt should not rise to unsustainable levels.
Other economists argue, however, that inflationary expectations are rising, reflected in bond yields, and this could drive actual inflation and force the Fed into the awkward dilemma of either raising interest rates, which could have a significant dampening effect, or further increasing money supply, potentially leading to greater inflationary problems in the future.
A lot will depend what happens to potential GDP. Will it rise over the medium term so that additional spending can be accommodated? If the rise in spending encourages an increase in investment, this should increase potential GDP. This will depend on business confidence, which may be boosted by the package or may be dampened by worries about inflation.
Additional packages to come
Potential GDP should also be boosted by two further packages that Biden plans to put to Congress.
The first is a $2.2tr infrastructure investment plan, known as the American Jobs Plan. This is a 10-year plan to invest public money in transport infrastructure (such as rebuilding 20 000 miles of road and repairing bridges), public transport, electric vehicles, green housing, schools, water supply, green power generation, modernising the power grid, broadband, R&D in fields such as AI, social care, job training and manufacturing. This will be largely funded through tax increases, such as gradually raising corporation tax from 21% to 28% (it had been cut from 35% to 21% by President Trump) and taxing global profits of US multinationals. However, the spending will generally precede the increased revenues and thus will raise aggregate demand in the initial years. Only after 15 years are revenues expected to exceed costs.
The second is a yet-to-be announced plan to increase spending on childcare, healthcare and education. This should be worth at least $1tr. This will probably be funded by tax increases on income, capital gains and property, aimed largely at wealthy individuals. Again, it is hoped that this will boost potential GDP, in this case by increasing labour productivity.
With earlier packages, the total increase in public spending will be over $8tr. This is discretionary fiscal policy writ large.
Articles
- Biden’s $1.9 trillion COVID-19 bill wins final approval in House
Reuters, Susan Cornwell and Makini Brice (10/3/21)
- Biden’s Covid stimulus plan: It costs $1.9tn but what’s in it?
BBC News, Natalie Sherman (6/3/21)
- Biden’s $1.9 Trillion Challenge: End the Coronavirus Crisis Faster
New York Times, Jim Tankersley and Sheryl Gay Stolberg (22/3/21)
- Joe Biden writes a cheque for America – and the rest of the world
The Observer, Phillip Inman (13/3/21)
- Spend or save: Will Biden’s stimulus cheques boost the economy?
Aljazeera, Cinnamon Janzer (9/3/21)
- After Biden stimulus, US economic growth could rival China’s for the first time in decades
CNN, Matt Egan (12/3/21)
- Larry Summers, who called out inflation fears with Biden’s $1.9 trillion COVID-19 relief package, says the US is seeing ‘least responsible’ macroeconomic policy in 40 years
Business Insider, John L. Dorman (21/3/21)
- With $1.9 Trillion in New Spending, America Is Headed for Financial Fragility
Barron’s, Leslie Lipschitz and Josh Felman (30/3/21)
- Biden unveils ‘once-in-a generation’ $2tn infrastructure investment plan
The Guardian, Lauren Gambino (31/3/21)
- Biden unveils $2tn infrastructure plan and big corporate tax rise
Financial Times, James Politi (31/3/21)
- The Observer view on Joe Biden’s audacious spending plans
The Observer, editorial (11/4/21)
Videos
Questions
- Draw a Keynesian cross diagram to show the effect of an increase in benefits when the economy is operating below potential GDP.
- What determines the size of the benefits multiplier?
- Explain what is meant by the output gap. How might the pandemic and accompanying emergency health measures have affected the size of the output gap?
- How are expectations relevant to the effectiveness of the stimulus measures?
- What is likely to determine the proportion of the $1400 stimulus cheques that people spend?
- Distinguish between resource crowding out and financial crowding out. Is the fiscal stimulus package likely to result in either form of crowding out and, if so, what will determine by how much?
- What is the current monetary policy of the Fed? How is it likely to impact on the effectiveness of the fiscal stimulus?
In a series of five podcasts, broadcast on BBC Radio 4 in the first week of January 2021, Amol Rajan and guests examine different aspects of inequality and consider the concept of fairness.
As the notes to the programme state:
The pandemic brought renewed focus on how we value those who have kept shelves stacked, transport running and the old and sick cared for. So is now the time to bring about a fundamental shift in how our society and economy work?
The first podcast, linked below, examines the distribution of wealth in the UK and how it has changed over time. It looks at how rising property and share prices and a lightly taxed inheritance system have widened inequality of wealth.
It also examines rising inequality of incomes, a problem made worse by rising wealth inequality, the move to zero-hour contracts, gig working and short-term contracts, the lack of social mobility, austerity following the financial crisis of 2007–9 and the lockdowns and restrictions to contain the coronavirus pandemic, with layoffs, people put on furlough and more and more having to turn to food banks.
Is this rising inequality fair? Should fairness be considered entirely in monetary terms, or should it be considered more broadly in social terms? These are issues discussed by the guests. They also look at what policies can be pursued. If the pay of health and care workers, for example, don’t reflect their value to our society, what can be done to increase their pay? If wealth is very unequally distributed, should it be redistributed and how?
The questions below are based directly on the issues covered in the podcast in the order they are discussed.
Podcast
Questions
- In what ways has Covid-19 been the great ‘unequaliser’?
- What scarring/hysteresis effects are there likely to be from the pandemic?
- To what extent is it true that ‘the more your job benefits other people, the less you get paid’?
- How has the pandemic affected inter-generational inequality?
- How have changes in house prices skewed wealth in the UK over the past decade?
- How have changes in the pension system contributed to inter-generational inequality?
- How has quantitative easing affected the distribution of wealth?
- Why is care work so poorly paid and how can the problem be addressed?
- How desirable is the pursuit of wealth?
- How would you set about defining ‘fairness’?
- Is a mix of taxation and benefits the best means of tackling economic unfairness?
- How would you set about deciding an optimum rate of inheritance tax?
- How do you account for the growth of in-work poverty?
- In what ways could wealth be taxed? What are the advantages and disadvantages of such taxes?
The BBC podcast linked below looks at the use of quantitative easing since 2009 and especially the most recent round since the onset of the pandemic.
Although QE was a major contributor to reducing the depth of the recession in 2009–10, it was barely used from 2013 to 2020 (except for a short period in late 2016/early 2017). The Coalition and Conservative governments were keen to get the deficit down. In justifying pay restraint and curbing government expenditure, Prime Ministers David Cameron and Theresa May both argued that there ‘was no magic money tree’.
But with the severely dampening effect of the lockdown measures from March 2020, the government embarked on a large round of expenditure, including the furlough scheme and support for businesses.
The resulting rise in the budget deficit was accompanied by a new round of QE from the beginning of April. The stock of assets purchased by the Bank of England rose from £445 billion (the approximate level it had been since March 2017) to £740 billion by December 2020 and is planned to reach £895 billion by the end of 2021.
So with the effective funding of the government’s deficits by the creation of new money, does this mean that there is indeed a ‘magic money tree’ or, indeed, a ‘magic money forest’? And if so, is it desirable? Is it simply stoking up problems for the future? Or will, as modern monetary theorists maintain, the extra money, if carefully spent, lead to faster growth and a reducing deficit, with low interest rates making it easy to service the debt?
The podcast explores these issues. There is then a longer list of questions than normal relating to the topics raised in the podcast.
Podcast
Questions
- Which of the following are stocks and which are flows?
(a) Money
(b) Income
(c) The total amount people save each month
(d) The money held in savings accounts
(e) Public-sector net debt
(f) Public-sector net borrowing
(g) National income
(h) Injections into the circular flow of income
(i) Aggregate demand
(j) Wealth
- How do banks create money?
- What is the role of the Debt Management Office in the sale of gilts?
- Describe the birth of QE.
- Is raising asset prices the best means of stimulating the economy? What are the disadvantages of this form of monetary expansion?
- What are the possible exit routes from QE and what problems could occur from reducing the central bank’s stock of assets?
- Is the use of QE in the current Covid-19 crisis directly related to fiscal policy? Or is this use of monetary policy simply a means of hitting the inflation target?
- What are the disadvantages of having interest rates at ultra-low levels?
- Does it matter if the stock of government debt rises substantially if the gilts are at ultra-low fixed interest rates?
- What are the intergenerational effects of substantial QE? Does it depend on how debt is financed?
- How do the policy recommendations of modern monetary theorists differ from those of more conventional macroeconomists?
- In an era of ultra-low interest rates, does fiscal policy have a greater role to play than monetary policy?