How to keep prices in check while fending off a recession

Central banks’ efforts to contain high and rising inflation are fuelling growth headwinds and threatening to tip the global economy into recession. But the proximate cause of today’s inflationary pressures is a large, broad-based, and persistent imbalance between supply and demand. Higher interest rates will dampen demand, but supply-side measures must also play a large role in inflation-taming strategies.

Over the past year or so, the rollback of pandemic-containment policies has spurred a simultaneous surge in demand and contraction in supply. While this was to be expected, supply has proved surprisingly inelastic. In labour markets, for ex- ample, shortages have become the norm, leading to cancelled flights, disrupted supply chains, restaurant closures, and challenges to health-care delivery.

These shortages appear to be at least partly the result of a pandemic-driven shift in preferences. Many types of workers are seeking greater flexibility – including hybrid or work-from-home options – or otherwise improved working conditions. Health-care workers, in particular, report feeling burned out by their jobs.

If this is true, the inflation picture must include an adjustment in relative labour costs. To bring markets back into balance, wage and income increases will be needed, even for jobs for which there was previously an ample supply of workers.

This transition will generate some inflationary pressure. Yes, nominal prices and wages have limited downward flexibility. But at a time of excess demand, firms generally try to pass on higher costs via price increases – and they often get away with it, at least for a while.

Lingering blockages associated with the pandemic, especially in China, which remains committed to its zero-Covid policy, are also fuelling inflation. But these blockages will eventually subside, as will short- to medium-term capacity constraints caused by shifts in the composition of demand (in terms of both products and geography), though some will persist for a while. Capacity – whether in ports or semiconductors – takes time to build.

But today’s inflation has deeper roots. Over the past several decades, the activation of massive amounts of underutilized labour and productive capacity in emerging economies has generated deflationary pressures. With those resources having now been significantly depleted, the relative prices of many goods are set to rise.

Moreover, there is a global push to diversify and, in some cases, localize demand and supply chains – a response to the increasing frequency of severe shocks and rising geopolitical tensions. A more resilient global economy is a more expensive one, and prices will reflect that.

The war in Ukraine has not only accelerated this supply-chain transformation, but also has caused energy and food prices to skyrocket, further exacerbating inflation, especially in lower-income countries. In the case of fossil fuels, a prior pattern of underinvestment in capacity at multiple points along the supply chain has compounded the problem.

Michael Spence is a Nobel laureate in economics.