This is the path of inflation in the United States, the UK, and Euro Area. After being stable around 2% for years, inflation suddenly jumped up to around 10% after the pandemic, while the price of some essentials like food and energy went up by even more than that, leading to a so-called cost-of-living crisis. But, after central banks started raising interest rates, inflation is now seemingly falling just as fast at it had risen.
So, does this mean that the inflation surge is finally over? Or will inflation surprise everyone once again by shooting back up?
The debate among economists is heated, especially after new IMF research revealed that during past inflationary surges, people often celebrated too early. So, to answer this question, I’ve immersed myself in the latest economic research and found some really interesting new papers that unveil what has been driving inflation all along and what has been causing it to fall.
Finally, based on these insights, I’ll make some predictions about whether or not you should expect another big inflation hit to your wallet.
So, let’s dive straight in and use the latest research to answer:
What was driving last years’ inflation spike?
Because, if you remember at the end of 2021, there was actually this giant debate about whether inflation was just a temporary phenomena, which they called transitory, or whether it was here to stay permanently. The main economic idea underpinning this debate was that inflation can be caused by either supply disruptions or by excessive demand. After all, if the total supply of goods and services in an economy is disrupted, and people still want to buy the same amount of them, then it makes sense that the overall price level in the economy goes up. But, on the other hand, if supply is stable, and the total demand for goods & services goes up, for example, thanks to government stimulus, then it also makes sense that we see overall prices go up.
Now, in this debate, members of team transitory, which included central bankers like Christine Lagarde, argued that the ongoing inflation surge was mainly caused by Covid related supply disruptions and made worse by temporary government support that stimulated demand. Therefore they argued, that inflation would be temporary and that central banks did not need to act. On the other hand, members of team permanent, like Harvard professor Larry Summers argued that temporary supply chain disruptions played a minor role while the real reason for the inflationary spike was excessive government and central bank stimulus, which could be permanent due to structural problems with our economies, and so central banks needed to raise interest rates immediately.
Looking back now, I think we can say that team permanent won the debate, in the sense that they convinced central bankers to raise interest rates and never use the word transitory again, after inflation rose to unprecedented highs in 2022. However, while members of team permanent seemed validated at the time, we now know that they got some pretty big predictions wrong. For example, professor Larry Summers insisted that the main reason inflation would get out of control was rapidly rising wages and that we would need sky high unemployment to get it back under control. At the same time, many non-economist members of team permanent, like gold and crypto investors, and even the Economics Explained channel here on YouTube, made wild claims that we were on the road to Zimbabwe style hyperinflation because of excessive money printing. And, yet here were are today, with falling inflation and still very low unemployment, and, indeed, as I predicted two years ago, the Zimbabwe comparisons were ridiculous from the start.
Then again, some members of team permanent now make the argument that central bankers simply listened to them and this is why inflation is now falling. Which, let’s be honest, could be true. But, at the same time, some members from team transitory have pointed out that actually, interest rate hikes have historically taken roughly 2 years to really make inflation fall in advance economies. So, maybe inflation is just dropping on its own right and, meaning that it was transitory after all. But, that it just became super transitory thanks to the massive disruptions to energy and food markets following Russia’s invasion of Ukraine.
So, both sides have really valid points, and yeah, given that there is no data about total potential supply and total potential demand in the economy, it initially looked like we would never be able to settle this debate.
That is until, economist dr. Adam Shapiro recently popularized a new technique which can quantify which part of inflation is driven by demand and which part by supply, by using simple economic logic. You see, if there is a supply disruption in a certain category like, cars for example, then car prices will go up, but since supply is disrupted units sold should go down or remain the same. On the other hand, if total demand in an economy is increased by, for example, more money in circulation, then you would expect to see rising prices combined with more cars sold.
So, then as you can see in this graph of inflation in the USA, economists were able to classify parts of inflation as supply driven, marked in green, ambiguous, marked in yellow, or demand driven, marked in blue. Now, what I think is striking when looking at this graph is that, according to this methodology, both supply and demand played a big role, with supply factors arguably playing a slightly bigger role at the peak of the inflation surge in 2022.
On the other hand, in Europe, this chart clearly shows that, while using a similar methodology, roughly 80% of producer price inflation could be attributed to supply shocks, which are the blue bars, while the yellow demand bars are far less important.
But, while this is interesting, it doesn’t really help us to distinguish between the different supply and demand factors.
Should we blame Russia or Covid? Should we blame the government or the central bank?
So, to get a different perspective, I found some other interesting studies which decomposed the drivers of inflation in different ways.
For example, have a look at this graph, produced by economists at the European central bank, where the green line on top of the bars shows total inflation, the blue bars show, so-called core inflation, by which they mean all categories without food & energy, the orange bars show the contribution of energy, and the red bars show the contribution of food items. Indeed, if we look at this, I think it becomes pretty clear, why team transitory was caught off-guard in Europe as energy and food inflation basically dominate, meaning that most of the inflation spike was likely caused by Russia’s invasion of Ukraine, not by government stimulus or Covid related supply chain disruptions.
But, okay, the blue bars are rising as well. So, let’s now dive a bit deeper into the core inflation that they represent, we can see in this new graph of core inflation in Europe that the orange and red bars, which here represent sectors affected by supply chain disruptions and Covid re-openings respectively, also play a major role.
So, for Europe, I’d argue that the evidence indicates that the fallout of the war in Ukraine can explain roughly 60% of inflation, while the pandemic can explain roughly 20% and, other categories can explain the other 20%.
However, if we check out the same graph for the United States, we can see that the picture there is pretty different. Sure, energy and food inflation also played a major role in the US. But, it can explain less than half of the inflationary spike.
What’s more, if we dive a bit deeper into core inflation in the U.S., we can see from the green bars, that a significant part of it was driven by increases in housing rents, especially since the second half of 2022.
So, indeed, I think this confirms the picture we got earlier that demand, and therefore stimulus played a bigger role in the United States relative to Europe.
Finally, while sadly, I couldn’t find these types of detailed studies for the UK, most reports I read indicate that its inflationary spike was driven by much the same factors as those in the Euro area, but made a bit worse by Brexit.
So, in conclusion, I’d say that based on these new studies, we can now see that, even though they lost the debate, team transitory was mostly correct. Inflation was largely driven by temporary supply factors until it was made way worse by the temporary energy and food problems caused by Russia’s Ukraine invasion and the economic war that followed. But, importantly, I think the difference between U.S. and European inflation could indicate that government support played a big role as well, as the U.S. had more stimulus.
But, is the stimulus now indeed coming to an end, as team transitory had argued, or could it be that the end of supply problems are just masking the rise of more demand led inflation, meaning that team permanent will be right in the end?
Well, to answer that question, let’s now dive into
What is making inflation go down so fast now?
Are the temporary supply chain disruptions now just coming to an end, has stimulus just ended, or is it simply that central bank rate hikes are already responsible for lowering inflation?
Well, simply put, if we look at the graphs again, we can see that it’s mostly been that the temporary supply problems are now finally going away
more specifically, it’s been a big reduction in energy price inflation which first helped reduce inflation in the United States, and now finally in Europe as well.
However, if we look into non-energy and food inflation a bit further, we can also see that a significant part of the decline in U.S. inflation has been driven by housing rents finally coming down a bit, as you can see from the shrinking green bars.
And, that last part could actually be the consequence of higher interest rates which have discouraged mortgage lending, and which likely caused house prices to go down, at least initially.
In conclusion, while central bank interest rate hikes are having some effect, so far it seems that inflation is now dropping fast because the worst economic effects of the Covid crisis and Ukraine invasion are now coming to an end.
But, what does that mean for our main question?
Is the great inflation surge is finally over?
Well, now that we know that the inflation surge was largely been driven by temporary disruptions, I think we that can make way more informed predictions about what will happen next.
But, before we get into them, a word of caution: predicting economic trends is a tricky, if not impossible, business, and the upcoming insights are purely speculative, based on available data.
Okay, first, I think that given the multitude of factors opposing inflation, another sudden surge is very unlikely. For instance: on the supply side recent statistics are yet to account for the significant reductions in food and energy prices since their 2022 peak. What’s more, on the demand side increased interest rates have already curbed mortgage growth and investment spending, while at the same time post-lockdown savings are now mostly exhausted. Finally, central bank surveys now indicate that people’s expectations of inflation are coming down, countering the fear that inflation will become a self-fulfilling prophecy.
Therefore, central banks now anticipate that inflation will return to 2% after a few years, with a stabilization at slightly higher levels than before due to:
- potentially increasing global manufacturing costs,
- and increased government spending on industrial policy and defense, both because of deglobalization and the move towards a multi-polar world
Finally, the big trend of global aging, might push wages up as fewer workers have to take care of the elderly.
So, actually, team permanent might still get the last laugh, even if most of the inflation surge was clearly transitory.
But, yeah, that is my take on the matter. Do you agree, or do you think I left crucial parts out. This is a very complex matter and I’d love to discuss it further with you in the comment section or on my Discord server that is exclusive for Patrons and channel members.