Inflation dynamics in a fragile economy

European Central Bank President Christine Lagarde has said that while both the US and Europe are struggling to contain soaring inflation, they are also “facing a different beast”, alluding to the dramatic rise in energy prices.

These thoughts chimed with panelists on a recent IMF’s 2022 Spring Meetings: Inflation Dynamics in a Fragile Global Economy, a discussion hosted by CNN business news anchor Richard Quest. The panel was made up of a distinguished body of economists who included London Business School’s Professor Hélène Rey; Gita Gopinath, First Deputy Managing Director, IMF; Nor Shamsiah Mohamad Yunus, Governor of Bank Negara Malaysia, and Andrew Bailey, Governor of the Bank of England.

Panelists were asked, What’s driving recent price spikes in inflation and how long will high prices last? and invited to delve into the ongoing surge in global inflation, exploring issues related to supply and demand factors and the persistence of rising price pressures. The impact of the war in Ukraine, the large increases in commodity prices - including food and energy - and the risk of inflation were also discussed, with panelists speaking about the toughness of central banks delivering on their price stability objectives, while protecting the ongoing recovery.

LBS’ Hélène Rey said that one ought not to be surprised by the present inflationary surge as the global economy has now experienced two supply side shocks in rapid procession that “have placed central banks in a difficult position”.

“We are now in a situation where these two shocks, one after the other, has created sizeable inflation It is starting to be persistent, and so the real question is, do we think that inflationary expectations are going to change and stabilise? On the one hand, do we believe that there is going to be a wage growth spiral taking place in some economies where the labour maket is tight. Moreover, will it be persistent or not? These are very important questions to answer if we want to know if inflation is going to be persistent or not.”

The Bank of England’s Andrew Bailey said that inflation would go higher, above seven per cent in the UK owing to the “re-set of energy prices”. How much higher inflation would go depended on the rise of energy prices, illustrating the challenges of making a prediction by making the point that wholesale natural gas prices were currently four times their long run average and has been at times eight times their long run average.

Mr. Bailey agreed with Professor Rey, saying that inflation would be hard to predict, “given the volatility and shocks we’re seeing, and the ongoing impacts of the war in Ukraine we’re seeing big terms of trade effect on imported goods, and energy imports and even some food which is having a real income effect”.

“With regard to the labour market, in the UK have a tight situation which looks more like the US environment than the continental European market. This gives rise to secondary inflationary effects,” he added.

The IMF’s Gita Gopinath said that the past two years have been extraordinarily unique that economies were difficulty to determine the imbalances between supply and demand.

The BoE Governor said that Covid had left a number of legacies, particularly goods and services legacies and a tightened labour market which were very hard to predict. He added that the build-up of unexpected saving begs two questions – how will people use those savings and also, like the US, “we have witnessed a fall in participation in the labour market in the UK and in other countries. Will people leave the labour market altogether, and use their cash to reevaluate their lives”.

Nor Shamsiah Mohamad Yunus observed that there were greater spillover effects which added to supply side shocks although in Malaysia as in other ASEAN counties “there are price caps across the region to mitigate the passing through of shocks into the wider economy”.

The panel then turned to the subject of fragility with the observation being made that a .5 per cent rise in interest rates indicated by Fed conveyed a sense that “things are going to get worse”.

Mr. Bailey said that one thing that we have learnt after the global financial crisis is the need to build resilience, but the definition of that word now needed to be stretched more broadly to include energy supply and food.

“We need to be focused on resilience in those areas – we must put more of our time and effort into a pattern of wider resilience,” he said.

Professor Rey concluded the discussion by observing that there was no easy answer to limiting Russian oil and gas supplied by Russia, with Mr. Quest commenting, “You either give a billion Euro a day to Putin or your risk throwing your economy into reverse”. Professor Rey added that there was a clear case in terms of the financing of the war” although clearly the devil is in the detail, with partial embargoes or a tax on gas and oil being considered.

“The oil market is more international and one has more latitude, but gas is more localised. Clearly, governments are trying to address this supply issue possible while providing more focus on green energy initiatives and the diversification of supply.”

The acute humanitarian crisis and the fact that money continued to flow into Russia’s budget to wage war is the principal crisis that urgently needed to be addressed added Professor Rey.