Transitory vs. Permanent: The Return of Inflation

Across the globe central bankers and politicians alike have been taken by surprise by consumer price index (CPI) readings. Within a couple of months CPI forecasts have more than doubled and year-on-year price increases are now beyond 6 percent in the US, and 4.5 percent in Germany (beyond 4 percent in the Euro area).

Central bankers in advanced economies have been focusing their efforts on a target inflation rate for a decade and a half and have repeatedly learned their dovish policies are ineffective at bringing targeted inflation up to a range of 2 percent. After the CPI gained momentum, dynamics became unsettling even for central bankers. Some economists and institutions are calling for a withdrawal of massive monetary support that resulted in a new (ultra-low and in some places even negative) regime of interest rates. They believe that keeping low interest rates provide a distortion in the real economy and lead to asset bubbles in financial markets. And more importantly, they argue current forces behind CPI increases are not dissipating soon enough, i.e. they are not transitory in their nature but permanent.

“Permanent” arguments are not convincing enough for central bankers, who point to supply chain disruptions that are induced by the Covid-19 environment. Namely, some logistics infrastructure has lower throughput, there are shortages in some materials and energy, and (an underlying cause) people simply can’t come to work due to Covid-related isolation. Material shortages are further worsened by inventory buildup – a precautionary measure implemented in times when supply is short and delivery dates uncertain. Monetary authorities argue inflationary pressures are transitory. Once the above problems are solved inflation will come down again (hopefully to a targeted 2 percent mark). As a result, they are still comfortable with keeping interest rates ultra-low, and extending bond purchases within the quantitative easing framework.

Getting the current situation wrong would be dangerous. Current real interest rates are negative by a large margin (approx. 400 basis points). Such a precarious situation cannot last for long without serious consequences. There are several redistributive effects on firms and individuals. Higher living costs will lead to higher wage demands, higher production costs and finally this will become a new game that ultimately leads to higher inflation expectations. Two predominant factors that were at work in keeping inflation low in the past decades were (deteriorating) population age structure across advanced economies and productivity gains in an increasingly globalised world. With recent geopolitical tensions and a reversal of a globalisation megatrend the resulting effect on inflation is unclear at best.

There are strong arguments against the root cause of today’s supply-chain imbalances. Namely, global trade volumes rebounded beyond pre-Covid period and are at historical high levels. This gives a hint that, perhaps, the main reason for late deliveries and material (and chip) shortages are not so much bottlenecks caused by missing workers, but fiscal stimulus that is simply fueling excess demand – an argument that embarrasses those who favour the “transitory” argument.

Central banks need a long time to build their credibility. However, it can be lost rapidly. By acting with the same arsenal against pandemic-induced economic problems as they would in a financial crisis (slashing interest rates and implementing QE programs) – resulting in multiplying their balance sheets – central banks already lost some glitter. I sincerely hope credibility stays in place for the advanced economies central banks and that their beliefs in transitory nature of current inflationary pressures don't put us all in dire straits.

Dr. Aleš Berk Skok, CAIA, FRM
Professor at SEB LU, Managing partner at ALPHA CREDO & Board Member at SCTA

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