Tackling the global inflation crisis

Dame DeAnne Julius speaks to Lyndsey Jefferson about what to expect from the cost-of-living crisis and its political consequences.

Interview
Published 29 July 2022 4 minute READ

Inflation is a huge issue in the UK and US, where it has reached a 40-year high of around 9 per cent, but it’s also a big problem globally. Can you explain why inflation is so high now?

It’s interesting that inflation is high across many big countries, because quite generally, in normal times, inflation is more country-specific. For example, the US may have high inflation while Germany has low inflation.

In this case, it really is striking that it’s hitting all the countries at once. When you look behind the scenes and ask why that is, it’s mainly because there have been some international developments, or shocks, as economists tend to call them, that have affected global markets, and therefore global prices.

In particular, the pandemic caused a lot of supply lines to just shut down. Then, the lifting of lockdowns and the big bounce back in most economies suddenly increased demand, while supply was still restricted. That was certainly a big factor.

But also, the Russian invasion of Ukraine has meant that a lot of normally traded goods that are shipped from both Ukraine and Russia, especially agricultural goods, are just not on the market. So, the price goes up because of the scarcity of supply.

What can people expect in the short term? Is a recession imminent?

It’s hard to know because no one really knows how the war in Ukraine is going to play out. No one knows whether grain supplies will be allowed out of the Black Sea, or what OPEC is going to be doing with oil supply to make up for sanctions on Russian oil.

It’s likely that prices will continue to rise at quite a rapid rate, at least through this year. This is simply because you cannot overcome supply shortages immediately.

DeAnne Julius

So, there are lots of reasons for being uncertain. But I think it’s likely that prices will continue to rise at quite a rapid rate, at least through this year. This is simply because you cannot overcome supply shortages immediately. It takes time to get supply chains working again.

Would you attribute any of the current inflation to corporate greed and price gouging?

I don’t think that has much of a role to play. Of course, companies want to protect their profits. So, when they see their input costs rising, they usually try to increase the prices at which they sell. But in a competitive market they often have to absorb some of the higher costs themselves.

It’s not just inputs like oil or gas that affect a lot of businesses, but also increasing wages as workers try to protect themselves from higher prices.  This dynamic is known as a wage-price spiral. Once it starts, it is increasingly hard to bring inflation down. Wages are the biggest cost of most companies in the service sector. And the service sector is a very big part of economies.

In the US, for example, the service sector is about 80 per cent of consumption. So, even if you are worried about gasoline prices, as Americans tend to be, that’s actually a small part of what you’re consuming. It’s restaurant, healthcare, and education prices that spur inflation, and all of those are affected by higher wages and domestic shortages of labour, not so much by international factors.

You mentioned energy prices as one of the main causes of inflation. Could price controls work so a windfall (excess profits) tax isn’t needed? In other words, could governments enforce price caps to avoid this situation to begin with?

Price controls can work in the very short term, but they’re counterproductive in the longer term. The US tried them back in the 1970s. Under Nixon, in fact, they suppressed prices for a while, but soon long queues formed at petrol stations as consumers panicked and supplies fell.

To help consumers, the best thing to do is give direct income support to low-income families who are hardest hit by high gasoline and food prices.

DeAnne Julius

If the price increase is caused by international factors, for example, oil shortages, then putting domestic price controls in place isn’t going to change that. It’s also important to remember global warming and climate objectives, and that governments don’t want to encourage oil consumption by suppressing oil prices below their natural level.

So, to help consumers, the best thing to do is give direct income support to low-income families who are hardest hit by high gasoline and food prices. Providing them with extra income while allowing high prices to suppress everyone’s demand for energy is a much better economic solution than putting price controls on oil or gas.

Some economists blame the COVID-19 rescue packages as one of the causes of inflation. What do you make of these arguments?

It’s a tricky one for governments, because on one hand, they want to protect consumers against high inflation. On the other hand, inflation is really caused by an excess of demand over supply.

So, if your supply is constrained, then you don’t want to pump up demand. There is evidence that in the US case, the very large package that the government put in place during the pandemic, to help people who couldn’t work, or companies who had to shut down, was probably too large. And it probably did increase demand more than was desirable, and indeed, enough to cause inflation to get out of hand.

It’s a bit of a fine balance. In the UK case, there was also a big (by international standards) support package during the pandemic that manifested itself in high savings by a lot of the population. Those savings now provide a cushion for many households. So, it’s hard to rollback history and say that was the wrong thing to do, because in fact, it has helped people get through this period of higher prices.

If I had one criticism of how governments reacted, it would not be on fiscal policy, but on monetary policy. In the case of the US, the eurozone, and to some extent the UK, central banks were slow in recognizing that inflation was not just a temporary phenomenon, and they needed to start raising interest rates to restrain demand.

Is there a light at the end of the tunnel when it comes to inflation? What can be expected in the longer-term?

The encouraging signs are that central banks are now catching up. They were certainly behind the curve, but now monetary policy is being tightened. Although there is a lag before it really affects demand in the economy, it’s already having quite an effect on financial markets. The major stock markets of the world have fallen dramatically since the beginning of the year.

The encouraging signs are that central banks are now catching up. They were certainly behind the curve, but now monetary policy is being tightened.

DeAnne Julius

So, higher-income people, those with wealth in the stock markets, have been hit pretty hard. That reduces demand. At the same time, lower-income people are hit by the cost-of-living. So, they too will reduce their demand. The combined effect will act to reduce inflation.

It’s likely that by the end of the year, prices will still be rising, but not as fast as they are now. In fact, the official projections of the Bank of England are that Britain will be back to the 2 per cent inflation target towards the end of next year. I think that timing might be a bit optimistic, but certainly, the central bank policies are underway to bring inflation under control.

Political consequences cont.

What kind of political consequences do you envision happening due to the cost-of-living crisis?

I think the economic situation means that incumbent politicians will face difficulties. They will be blamed for high inflation even when its causes are partly international shocks like the pandemic and the Russian invasion. Voters and consumers tend to blame the party in power. So that may not bode well, either for the Democrats in the US, or the Conservative Party in the UK.

The other, perhaps more important issue is that some developing countries are facing serious food shortages, or food price increases, especially in the Middle East and North Africa. This could cause protests and uprisings like those of the Arab Spring. So, the current negotiations over allowing grain exports out of the Black Sea and the roles of the UN, Turkey, Russia and Ukraine are a critical example of the politics behind high prices.