Who is Beating Inflation?

Due to a consequence of mistakes in fiscal and monetary policies, inflation in 2022 has jumped to levels not seen in decades in the western world. The good news is, US inflation now seems to be heading back down to 3%, the UK has broken through the 8% barrier, while Europe is still hovering around 5.5%.

As the US always leads in most things, one should expect both the UK and the Euro area inflation to slowly trend back down to the ranges that policy makers like by year-end. Therefore, two questions beckon. Have we beaten inflation? And if so, who beat inflation?

The answer to the first question is that we need to see a few more readings to be sure that inflation has been tamed.

The answer to the second question is more interesting. We need to look at the causes of inflation. In the last three years, the world has witnessed unprecedented disruption due to the war in Ukraine, and the effects of Covid-19 which forced governments around the world to lock people at home and pay supplemental income to those who lost their jobs or simply couldn’t ‘work from home’. Governments that prevented people from working had to take on the responsibility of paying them, and this was done both indirectly, by helping companies and directly, individuals.

The problem was that governments made a dosage mistake. Most people in the developed world, especially the relatively affluent young professionals, tend to spend an important portion of their income on entertainment, eating out, and travel. Due to long lockdown periods, the supplemental income that people received, that was not spent, increased savings. These savings were initially invested in stock markets, cryptocurrencies, watches and the like. But then, as the world reopened, pent up demand for travel, restaurants, and entertainment resulted in a flood of money into a plethora of services, that were themselves facing supply shortages in every aspect imaginable while they ramped up their capacities. Scarcity of service staff at restaurants, handlers at airports and the inability to refill old positions due to people moving for various reasons during the long lockdown period lead to higher costs in the aftermath of the lockdowns. And to compound policy errors, as soon as he got elected, Biden decided to give more money to more people in an unprecedented stimulus package while the effects of Covid-19 were subsiding, in a move that most economists thought was a colossal fiscal policy error.

The result: low supply of goods and services, high savings, new stimulus, and pent-up demand, high inflation. Prices moved up, and if history is an indicator, they will not really come down. There has been a parallel shift in the curve but inflation is not a measure of price levels, it is a measure of acceleration. Just like getting sucked in to your seat on a plane during take-off at 250MPH but not feeling anything when it stabilises at 550MPH, what is felt is acceleration, not the static higher levels of speed.

Monetary authorities, who were asleep at the wheel when inflation started moving up and were still priming the economy with low rates and quantitative easing (remember QE? Simply put, buying bonds and increasing money supply), had to catch up rapidly and deliver nearly constant monthly interest rate increases that have brought short-term rates around the world from around zero to the 4-6% band.

The question to ponder is, was it higher rates that was taming inflation? If inflation went up because of a supply and demand mismatch that has since subsided, perhaps inflation too has now stabilised after moving the prices higher. This would mean that this stability has less to do with higher rates and is more a result of the absence of the reasons that brought it up in the first place. Or alternatively, we have entered a price-wage spiral reminiscent of the ‘70s that will take much longer to cure.

The next few months will tell. In the meantime, medium-term low risk bonds could be a bargain in either scenario.