The Spectre of Inflation

Causes of inflation

On a monthly basis Dutch inflation is currently well above 5% in comparison to a year ago. This should be viewed in perspective, however, because inflation is only 2.7% on an annual basis, not much higher than the ECB’s 2% target for inflation. The DNB (Central Bank of the Netherlands) expects an inflation rate of 3% in 2022. This means that the current inflation is of an entirely different order than the stagflation of the seventies, as is evident from the Dutch consumer price index (CPI) depicted in Figure 1. With one of the lowest levels of unemployment in the EU, there is no evidence of a stagnating economy.

When using the longer-term perspective, it is also important to examine how wages have developed in relation to inflation. As Figure 2 shows, nominal wages have consistently increased by more than consumer prices since 1970. In real terms the Dutch are better off than fifty years ago! Over time unexpected bouts in inflation are usually offset by a wage increase. 

It should be noted that if inflation is caused by a rise in the oil prices charged by OPEC countries this cannot be compensated by a general increase in wages. Since The Netherlands is a net importer of energy, an increase in the price of energy causes a deterioration in the terms of trade. It is therefore impossible to fully compensate for higher energy costs because the national pie has shrunk, just like in the seventies. For the same reason this cannot be mitigated through monetary policy. In time though, productivity growth in the Netherlands will compensate such this loss.

The most important component driving up the current inflation level is the price of energy. Added to this, are the increased costs of domestic and international transportation. At the same time, pandemic-related government aid programmes and monetary purchase policy also play a role.

Energy prices are driven by the international prices of oil and gas, and these have increased sharply due to a combination of three factors. The first factor is OPEC’s more or less monopoloid position. The second factor is the energy transition. The demand for clean energy often outstrips the capacity. The third factor is geopolitical in nature, in which restraints on deliveries are used as political leverage.

Because oil and gas are essential inputs in practically everything we produce and consume, high energy prices have a dampening effect on the national income. For example, between 2010 and 2014, the price of oil hovered around 100 dollars and impeded the recovery from the credit and the eurozone crisis. But when the price of oil halved in 2014 due to competition from American oil produces, the economy rebounded strongly. The price of crude oil now hovers around 100 dollars.

Disruptions in both the manufacturing chain and the transport chain are in part also responsible for the recent inflation. For example, the pandemic has caused misallocation in international container shipping, but one can expect that these problems will be ironed out over the course of time.

At the very beginning it was thought the pandemic would lead to deflation. This was indeed briefly the case in the spring of 2020. But the economy quickly revived, and the intervention of central banks stabilised the financial markets. Governments set up aid programmes that placed a floor under supply and demand.

These aid schemes, however, opened the door to inflation. In the US, for example, aid was provided in the form of stimulus cheques sent to all Americans. This was indirectly financed by the Fed’s by purchases of government debt. Essentially, the aid provided boiled down to distributing helicopter money as proposed by Friedman, the well-known monetarist. As consumers started to spend these cheques, and given the production shortfalls, prices shot up. Thanks to the generic nature of the aid in the US, inflation increased more rapidly than in Europe, where the aid was more targeted. At the same time, the huge purchases of government debt, i.e., the so-called Quantitative Easing (QE), of the ECB and the Fed led to extremely low interest rates. This in turn led to a surge in the demand for stocks and homes (since loans could be cheaply financed). This consequently resulted in asset price inflation.

High inflation is costly for the economy because it comes with higher price uncertainty. It reduces investment as the future returns are more difficult to determine.  High inflation also curbs consumer spending. That’s why a tight monetary policy backed by high interest rates was used to bring down inflation in the early eighties. Afterwards, price increases remained subdued as a result of China joining the World Trade Organisation in 2001. Since then, the resulting increased global competition limited the room for increases in real wages in the OECD.

Monetary and budgetary policy

What is monetary policy about? The objective of European monetary policy is to bring about a low inflation rate of about 2%. Instruments used to achieve this objective include the interest the ECB charges to commercial banks, and the amount of public debt it buys or sells (QE). An accommodative monetary policy consists of low interest rates and an expansive QE. Accommodative monetary policy helps quell an acute financial crisis, while a tight monetary policy is effective in lowering high rates of inflation. The latter is achieved by setting a high interest rate and low QE. High interest rates diminish the willingness to invest or incur debts, and they constrain the wage-price spiral.

Staunch monetarists endorse Friedman’s adage that inflation is always caused by an excessively accommodative monetary policy. But is that really the case? The current upsurge in inflation is driven by high energy prices and shortages in global transport and manufacturing chains (chips, raw materials and workforce). This is similar to the effects of the oil price increases in the seventies, and monetary policy has little impact on external price increases. An accommodative policy to soften the blow won’t help because inflation will get bogged down in leapfrogging between producer prices and wages.

Reducing the economic disparities between the Northern and Southern eurozone countries is another case where the ECB is powerless. Structural reforms are needed in order to achieve convergence. These reforms include elements such as enhancing labour market flexibility, increasing competition and reining in national debt so as to rein in the government hold over the economy. The convergence that was originally intended when the euro was introduced has failed to materialise. The Stability and Growth Pact (SGP) was introduced to induce convergence. However, the SGP has never acted as a disciplinary force because of a lack of political will to enforce its rules. There is no binding mechanism at the EU level. Consequently, the tendency to generate excessive government debt has remained, resulting in pressure on the interest rate spreads between eurozone countries. 

The ECB had to intervene to preserve the eurozone monetary union in 2015. Interest rates had dropped thanks to the expansive QE policy, which sustained the sizeable public debt of some eurozone countries. There is little willingness in the eurozone to reduce the high government debt. A French-Italian lobby is advocating for adjusted SGP requirements. And it appears that Germany and the Netherlands are also loosening their budgetary rules. In Germany, the Constitutional Court’s assertion that the ECB was in fact engaging in monetary financing of government debt was ultimately rejected. Major investments are needed in the Netherlands, according to the Analysis of the Coalition Agreement 2022-2025 released by the CPB (Netherlands Bureau for Economic Policy Analysis). The sustainability of government debts is facilitated to an important extent by the considerable purchases made by the ECB. Because of this, QE has fuelled higher share prices and house prices. If there is no change in policy, interest rates will eventually rise, and this may impair the sustainability of the public debt.

In view of the inflation, what would be an appropriate interest rate for the Netherlands? Taylor's rule of thumb, which characterises the policy of many central banks, states that with full employment interest rate should be set at one and a half times the difference between inflation and the inflation target. With an annual inflation of 2.7% and an inflation target of 2%, an interest rate of 1% would thus be appropriate. This is approximately 75 basis points higher than the ECB’s current lending interest rate. For the Netherlands, the ECB interest rate is too low and it thus fuels the domestic inflation.

Even though the ECB sets the interest rate, the Netherlands still determines its own budgetary and fiscal policy. This policy is usually employed to bring about structural improvements or to compensate the disadvantaged. It should be noted that budgetary and fiscal instruments can also be utilised to bring inflation under control. Limiting government expenditures or raising taxes usually has a dampening effect on the business cycle. Given that the Netherlands is currently in an economic boom, it is important that any new policy introduced should have the lowest possible inflationary effect. For example, certain public investments could be spread out over time because the required capacity (manpower) is not available, or the tax burden could be allocated differently. Measures that promote competition can also be helpful in preventing sharp price increases.

Forecasts?

The ECB anticipates that the upsurge in inflation is only temporary. The argument is that supply chains and production processes will return to normal once the pandemic subsides. Insofar the jump in energy prices is a one-off, it will not drive inflation rates structurally higher. This outlook is supported by the relatively low premiums being paid in the market for financial instruments that cover future inflation risk. Based on French data, the premium for inflation compensation for five years ahead is hovering around 2% (this is only a half-percent higher in the US), see Figure 3.

The question remains as to how well market prices can serve as an indicator for inflation in the future. In March 2020, premiums for inflation hedges dropped because the pandemic was initially considered to be strongly deflationary, and they rebounded quickly once the economy started to recover. The prices for inflation hedges thus appear to follow the current state of the economy rather than these anticipate future economic developments. For example, no one predicted that the recent geopolitical developments related to the energy supply would play such a significant role. Based on this type of data and forecasts, it is unlikely the ECB will raise interest rates any time soon. This can also be attributed in part to the ECB’s concerns regarding rising interest rate disparities between eurozone countries.

Forecasting inflation is difficult because inflation can be driven by so many factors. In the medium run, however, there is one factor that can play a decisive role: demographic developments in the OECD and China. Except for Africa and perhaps India, the proportion of retirees and young people relative to the size of the working population will rise sharply, see Figure 4 with the dependency ratios. This means that considerably fewer active persons will have to provide for a larger section of the population. If the labour factor becomes scarcer, this will drive up wages, which in turn drives up inflation. Since all major eurozone countries pay the bulk of pensions from the current budget, this will also have a price-increasing effect if taxes are raised. Over time, this can significantly drive up the European inflation rate.

Conclusion

The current fluctuations in the inflation rate are driven by volatile external factors, but for the moment they have not yet become entrenched. That is why it is recommended that the formulation of any new economic policy should take inflationary repercussions into consideration. In the short term, geopolitical developments could throw a spanner in the works. And in the long term, developments such as the growth of the European mountain of debt and demographics could later drive inflation up even further.