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An opinion about inflation

An opinion about inflation
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ARTICLE TYPE
Market Updates
TOPIC
Macro,Opinion
PUBLISHED
July 14,2021
READ TIME
3 mins
AUTHOR
Serdar Kucukakin
SHARE
Back
ARTICLE TYPE Market Updates
TOPIC Macro,Opinion
PUBLISHED July 14,2021
READ TIME 3 mins read
AUTHOR Serdar Kucukakin
SHARE

Everybody has a thought-out opinion about inflation and more importantly the positions are very clearly divided into two camps: those that feel high inflation is transitory and those who advocate that high inflation is non-transitory. It would be very naïve of me to think that I could convince people in either camp to change or at least to re-evaluate their point of view.

 

No, as an economist I will only tell you what the questions are I am asking myself in the current situation and leave it up to you to decide how relevant these questions are for you.

 

How long will it last?

It is an undeniable fact that inflation has jumped in Europe and the US. Consensus forecast expects inflation to average 1.9% and 3.7% this year in the eurozone and the US respectively, up from 0.3% and 1.2% last year.

 

Like I have argued previously there is  a clear one-to-one relationship between (un)pausing an economy and economic activity. Or to put it differently: the pausing of economies last year was extraordinary and thus the events following the unpausing this year should also be quite extraordinary. Look at Italy, for example. The average economic growth of Italy since the introduction of the Euro in 1999 is 0.03%! Italy is clearly not a front runner when it comes to economic growth. However, for this year consensus expects economic growth to average 5%, after a contraction of almost -9% last year.

 

This expected economic growth rate for Italy means that something very special is going on in the European economy after the unpausing. The last time Italy registered an economic growth rate above 4% was in 1988, which is arguably over a generation ago. By the way, the eurozone is expected to grow 4.5% this year after a contraction of -6.5% last year.

 

These extraordinary economic developments, amplified by supply issues and rising commodity prices, should lead to extraordinary pricing developments. According to consensus forecasts this will surely be the case this year.

 

How long will this extraordinary situation last? And what are the possible scenario’s further down the road?

 

Possible scenarios

There are four possible scenarios: (1) both economic growth and inflation settle on a higher plateau, (2), economic growth settles on higher plateau, while inflation eases back to pre-corona-levels. (3) inflation settles on a higher plateau, while economic growth ease back to pre-corona-levels, (4) both economic growth and inflation fall back to pre-corona levels.

 

The first two scenarios and especially the second one could be considered Goldilocks scenarios: The eurozone is enjoying higher economic growth, while not having to pay for it via higher prices. Is this possible? Yes it is (in theory). Potential growth is essentially defined as: how many people there are (quantity) and what they do (quality/productivity). We know that the input of labour is stagnant or even declining in many European countries. This situation will only get more pronounced in the period ahead. So the higher economic growth should then come from “what they do”.

 

The question is: Will we see a positive trend break in Europe in terms of productivity growth in the coming years? I know that hopes are quite high. The website of the European Union says that: “The EU’s long-term budget, coupled with NextGenerationEU (NGEU), the temporary instrument designed to boost the recovery, will be the largest stimulus package ever financed in Europe. A total of €2.018 trillion in current prices will help rebuild a post-COVID-19 Europe. It will be a greener, more digital and more resilient Europe”.

 

The third scenario seems to be a doom scenario: Europa is paying the price for something it is not getting, namely higher economic growth. This scenario has happened before. In the seventies of the previous century many Western countries experienced stagflation. The negative supply shock that caused the stagflation back then was a sudden/sharp and continuous increase of oil prices. Currently, anti-globalization is seen by many as a possible threat that could cause a negative supply shock with adverse effects on economic growth and price developments. We actually already got a sneak preview of anti-globalization policies and its effect on global economy before the pandemic in the Trump-era.

 

Looking ahead, professor Kenneth Rogoff, the co-author of the 2009 bestseller: “This time is different: Eight Centuries of Financial Folly”, argued in June last year that Covid will lead to a big boost to anti-globalization. The two periods, the oil price shock of the 1970s and the anti-globalization-sentiment currently both have one common denominator: Politics is  the ignitor of the negative supply shock.

 

Looking ahead I can’t help wonder if politics will indeed influence the economic developments, and if so, how much. Stakes are quite high.

 

The last scenario is actually a continuation of what we used to in the pre-coronavirus era: Low inflation and low economic growth. Since the start of the eurozone, economic growth averaged 1.1%, while inflation was 1.6%. Though, there are two different periods here when it comes to inflation developments: pre-Global Financial Crisis and after. In the pre-Global Financial Crisis period the ECB had arguably its Golden Age. From the start of the Millennium up to the third quarter of 2007 inflation oscillated around the inflation target of the central bank. Since 2008 inflation developments have become way more volatile.

 

The question is how much of this volatility can be attributed to the subsequent crises (Global financial crisis, European sovereign debt crisis and the current pandemic) and how much can be attributed to the monetary policy of the ECB. Maybe it is a combination of both? I am also asking myself how much our judgement of monetary policies  has changed in the past decade and if this would influence the tightening and easing cycle of the monetary authorities. If someone would have told us before the Global Financial Crisis what central banks would be doing since the Global Financial Crisis, all of us would have said that was absolutely impossible.

 

In the end, I am hesitant to opt for any of the four scenarios mentioned. There are too many moving parts. I just need more input. So I will keep on asking questions.

 

Is this time different?

This is one of the most asked questions in economics. Indeed, in the current setting this phrase is used by both sides, the transitory and non-transitory advocates of inflation, to support their views. I think that both sides have a case in point. As far as I can tell it is the very first time we halted the global economy. And with a lack of previous experience existing textbooks may not fully capture all the possible scenarios in the current setting.

 

I do recognize that crises lead to changes in economic dynamics because of changes in policy setting. Just look how economic/monetary setting have changed after the Global Financial Crisis.

 

At the same time, I am not sure if the law of economics, which essentially examines human behavior, will change that easily, especially for collective behaviors. From this perspective I think I agree with Mark Twain who said: “History does not repeat itself, but it rhymes”: History does not repeat itself exactly, but many of the same patterns tend to repeat itself.

 

In the end I guess the main question is what is exactly meant by transitory (are we talking about months, quarters or years), but also what factors could flip the coin in favor of one the four scenarios. Professor Rogoff is providing some input here, but I am not sure if like his view. I just hope that his view was influenced by the pandemic at the time of the interview. For now I will just keep on asking questions.

More about the authors

Serdar Kucukakin Senior Sovereign Research Analyst

Serdar Kucukakin is a senior sovereign research analyst and is responsible for sovereign analyses of Central European countries and the Middle East.

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