Inflation: could covid-19 cause prices to rise?

Historical Context and Current Anomaly

• Central banks traditionally believed that keeping inflation on an "even keel" ensured overall economic stability.
• For the past decade, inflation has defied traditional expectations by remaining low despite high employment rates prior to the pandemic.
• This persistent low inflation suggests central banks possess less economic power than previously anticipated.
• The global economy is currently facing profound uncertainty, heightening the urgency to resolve this "great inflation mystery."

Definition and Economic Impact

• Inflation is defined as the rate at which prices increase across the entire economy (e.g., Big Mac prices rising from under $3 to nearly $6 over 20 years).
• The traditional mechanism for high inflation is "too much money chasing too few goods," driven by excessive money printing, low interest rates, or supply shocks like wars.
• Moderate inflation is generally harmless, but high, volatile, or unexpected inflation damages the capitalist system by complicating long-term planning and lending.
• Countries with high inflation experience a breakdown in long-term borrowing due to uncertainty regarding future returns.
• Most central banks target an inflation rate of approximately 2% to avoid economic extremes.
• To curb inflation, central banks raise interest rates to increase borrowing costs, slow the economy, and reduce price pressures.

The Phillips Curve Theory and Historical Application

• The Phillips curve, derived from 1958 observations by New Zealand economist A.W. Phillips, posits an inverse relationship between unemployment and wage growth.
• The theory suggests that high employment leads to rising wages, which forces firms to raise prices to cover costs, thereby increasing inflation.
• Conversely, high unemployment halts wage growth and suppresses price increases.
• This theory guided policy until the 1970s, when oil price spikes and Vietnam War spending triggered rapid inflation in the US.
• Federal Reserve Chair Paul Volcker implemented the "Volcker shock" in the 1980s, raising interest rates to a record 20%.
• The Volcker shock successfully reduced inflation from double digits but resulted in mass unemployment in the US.
• Following this period, the relationship between employment and inflation failed to predict economic behavior, leading to the modern conundrum.

Modern Economic Anomalies and Theories

• During the 2007–2009 global financial crisis, mass unemployment did not result in a significant drop in inflation.
• By 2019, the US unemployment rate hit a 50-year low, yet inflation remained mysteriously stagnant.
• The 2019 data prompted some economists to declare the Phillips curve "dead," while others suggested it was merely "hibernating."
• Anchored Expectations Theory: Prolonged low inflation may have led consumers and firms to no longer expect price rises, causing firms to hesitate raising wages or prices even during labor booms.
• Globalization Theory: An influx of cheap imports from emerging economies exerts downward pressure on prices, limiting central banks' ability to offset this with higher interest rates given the post-2008 low-rate environment.
• Wage Rigidity Theory: Firms avoided cutting wages during the financial crisis to protect morale, which subsequently slowed wage and inflation growth during the recovery phase before the pandemic arrived.

Pandemic-Era Policy and Future Outlook

• The US Senate unanimously approved a $2 trillion economic stimulus package during the pandemic.
• This legislation included lowering interest rates to nearly zero.
• The pandemic fostered unprecedented cooperation between central banks and governments, involving direct money printing by central banks alongside government stimulus spending.
• The consensus is that government borrowing and spending can stimulate the economy without triggering upward interest rate pressure, provided central banks accommodate the liquidity.
• This policy coordination is viewed as a potential mechanism to lift inflation from historical lows and repair the global economy.