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Inflation bug spreads far and wide

An exponential rise in prices is leading to an unprecedented lower economic growth across the world amid the US Federal Reserve increasing interest rate by 
75 basis points

The Western world is in the middle of decadal high inflation. Inflation is the annual rate of price rise. The retail inflation in the US was 8.6 per cent in May. The last time the US saw a rate of inflation higher than this was in the late 1970s and early 1980s. Given that, the retail inflation is at a more than four-decade high.

Along similar lines, in April 2022, the retail inflation in the UK inflation stood at 7.8 per cent, the highest since April 1991, more than three decades back. In the eurozone, the inflation is expected to be at 8.1 per cent in May, up from 7.4 per cent in April. The eurozone consists of countries, which use the euro as their currency.

So, what are the reasons behind exceptionally high inflation? How is this inflation spreading across the world? Let’s look at this pointwise.

When the Covid-19 pandemic broke out, the economic activity in the rich world collapsed. This meant that the economies were staring at an economic depression of the kind they had last seen in the Great Depression in 1929 and the years that followed. This had to be avoided at any cost.

The central banks of the rich world got into action and printed a lot of money to drive down interest rates. They also indirectly handed over this money to their respective governments. The governments, in turn, sent out cheques to citizens or deposited money directly into their bank accounts.

The idea was that at lower interest rates people would borrow and spend money. At the same time, they would also spend money that governments had deposited into their bank accounts. This would benefit businesses and in turn, prevent a depression. While an economic depression was prevented, putting money directly in the hands of citizens increased their purchasing power. This led to the demand for goods and services going up. Nonetheless, their supply did not increase at the same time and sent prices soaring, especially in the last 12 months as the pandemic has receded and more people have stepped out of their homes.

In fact, the supply of goods in many cases contracted. Over the years, the success of globalisation has ensured that a lot of production is outsourced to factories based in China and other parts of the world. As the pandemic spread, supply chains broke down.

In fact, as Anthea Roberts and Nicolas Lamp write in Six Faces of Globalization — Who Wins, Who Loses and Why it Matters: “The average automobile contains about 30,000 parts, with one analysis finding that Toyota relied on 2,192 distinct firms (both direct and indirect suppliers) in its production process”. And given this, “when China shut down its factories, global supply chains were thrown into disarray, with carmakers from Italy to America and South Korea to Japan sitting idle awaiting parts from China”.

In their quest for great efficiency, the global automobile manufacturers had taken out any redundancy in their system. One impact of this was the rise of systems leading to large automobile manufacturers maintaining little inventory of the intermediary goods they needed to build a car.

As Roberts and Lamp write: “Private actors in a market are unlikely to produce high levels of redundancy, as this is economically less efficient for each of them. But fat profit margins can entail razor-thin margins for error”. Hence, as the global supply chains broke down due to the pandemic, production of new cars collapsed and the demand for used cars went up with their prices soaring across the United States.

In fact, China has followed a no-covid tolerance policy. This has led to entire cities and industrial areas being shut down whenever a few cases of covid have broken out. Recently, the city of Shanghai was shutdown and that unsettled global supply chains all over again. In a globalised world, this pushes up inflation.

The war in Ukraine has made things worse. Russia is a huge supplier of commodities to the world. It is the world’s largest exporter of wheat. Ukraine is the world’s fifth-largest exporter. This supply is currently largely unavailable to the global market. Along with this, wheat surplus countries like India have banned exports to control the price in the domestic market. This has made things difficult for countries like Egypt, Turkey, China, Indonesia etc., which import large amounts of wheat. Russia is also the world’s largest exporter of fertilisers. This has pushed up fertiliser prices, which in turn has pushed up food prices in general.

Russia also happens to be the world’s second-largest exporter of oil and natural gas in gaseous state, and the third largest exporter of coal. This has pushed up energy prices across large parts of the world, feeding into retail inflation.

Higher inflationary expectations have seeped into the calculations of people. In the US, the median one-year ahead inflationary expectations increased to 6.6 per cent in May. This has led to people demanding higher wages than they did in the recent past. This can essentially lead to a situation where it becomes tough for central banks to control inflation.

These were the major reasons behind high inflation in the Western world. While high inflation in the Western world is a given for this year, the question is how does it impact other parts of the world?

As we saw earlier, the high inflation has been driven both because of increased demand as well as supply problems. While central banks cannot do anything about the breakdown of supply chains and the war in Ukraine, they can increase interest rates to control the demand side of things.

On June 15, the US’s Federal Reserve, the American central bank, raised the federal funds rate, a key short term interest rate, by 75 basis points. This was the biggest increase in 28 years. One basis point is one hundredth of a percentage. The European Central Bank has said that it plans to raise interest rates by 25 basis points in July and by at least 50 basis points in September.

Over and above this, the central banks also plan to take out some of the money they had printed and pumped into the financial system post the spread of the pandemic. The US’s Federal Reserve plans to take out close to a trillion dollars until May 2023. This will also push up interest rates. As the interest rates in the US rise, money will move out of stock markets across the world and move to the world’s largest economy, leading to stock prices falling and currencies losing value against the American dollar. In fact, this is already happening.

The central banks of the rich world will try to control consumer demand by increasing interest rates. This will dampen consumer demand in the US as well as the eurozone. The US is the world’s largest importer of goods. Any fall in consumer demand in the US will have an impact on exports driven businesses of many countries, slowing down economic growth in those countries.

Fitch Ratings, a global rating agency, expects the American economy to grow by 2.9 per cent this year, against 3.5 per cent earlier. In the case of China, the economic growth this year is expected to be at 3.7 per cent against 4.8 per cent earlier. China’s growth will slow down because of the lockdowns that the country implements as a part of its zero-tolerance to the Covid-19 policy. The slowdown in American consumer demand will also impact Chinese growth negatively. A slowdown in Chinese growth will impact other countries from which China imports goods and services.

To be sure, inflation will lead to lower economic growth across the world.

Vivek Kaul is the author of Bad Money