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There's inflation, and now what?


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The World

Antonio Moreno

Full Professor from Economics

It seemed that it was not going to come back, but inflation is once again rearing its ugly head. It is almost 30 years since the last time CPI inflation reached levels above 5%. This is obviously not good news. First, because it implies a loss of purchasing power for a large part of the population with the consequent damage to low incomes, because such high inflation was not anticipated, and because in the current situation it will not be possible to raise average salaries by this amount. Moreover, even if some prices of goods and services do not rise, their quality may decrease, since companies could adjust for the provision of the service instead of the price.

Supply and demand factors have led us to this status. On the supply side, energy prices are rising by leaps and bounds, increasing fixed costs for companies and the self-employed. In turn, disruptions in global assembly lines are restricting supply, increasing delays and driving up prices. On the demand side, several factors are pushing for more inflation: during Covid-19, much was saved due to pandemic uncertainty, and now that this unknown has been partly cleared up, consumption is up sharply relative to 2020. Alongside this, overall fiscal and monetary policies remain quite expansionary, which supports consumption, investment and the public expense .

The fact is that we were coming from very low inflations in the previous decade and our concern was more the robustness of growth than inflation. So we were sharpening our weapons for a different battle than the one we now face. Close to deflation, we wanted some more inflation - or at least inflation average around 2% - to compensate for previous too-low inflations so that we could make policies somewhat more expansionary. Now we have the opposite problem: inflation above goal of 2%. It is clearly easier to make expansionary policies after low inflation than contractionary ones after high inflation, as this would imply monetary restrictions and higher rates, which in an indebted country like ours would surely lead to a recession given the fragility of the current recovery.

Everything would be easier if inflation were transitory. After all, if it is only a matter of months and then we return to normality, everything would be settled with a slight loss of purchasing power. Will this inflation be transitory or permanent? Looking at the various factors, it is reasonable to think that the post-Covid production imbalances should be resolved. In fact, some companies are already announcing that the shortages should be temporary. On the demand side, the post-Covid increase in expense associated with reduced uncertainty should also be temporary.
uncertainty should also be temporary.

More worrying and uncertain is the inflation resulting from the rise in energy costs. Spain is still a country with a net foreign dependence in this area, and this increase in energy prices will be passed on to other sectors - memories of the end of the 1970s are not particularly edifying in this respect. The differential between CPI inflation and core inflation (which does not include energy and food prices) is enormous (4%), but it is more than likely that companies will pass on these energy costs to their sectors and products, so that core inflation should rise in the coming months. In this sense, countries such as France have a less structural problem than Spain, which should focus on securing energy supply - through agreements with neighboring countries with energy surpluses, more effective regulation to manage the energy market dominated by a few companies, as well as lower taxes on energy consumption - and thus be able to absorb current and future supply shocks.

On the other hand, central banks will have to navigate a delicate balance between controlling inflation through less expansionary policies and avoiding increasing the financial costs of companies, households and governments. One variable core topic in this regard will be inflation expectations. To the extent that these expectations beyond one year are maintained at around 2%, there will be more confidence that inflation is under control. Over the past decade, expectations of rising rates have been successfully kept in check.
rate hike expectations at bay. Now the task is more complex, as it is not an operational goal (short rates) but an ultimate one (inflation). Also, on the fiscal side, it is crucial for the government to have a credible fiscal consolidation path in the medium term deadline, which will also result in a better control of inflation and its expectations, and thus in a lower overall loss of purchasing power.