The Return of Inflation: Causes, Complacency, and the Risk of Persistence

• Inflation has rebounded after 30-years of low inflation due to expansionary monetary and fiscal policies during the pandemic.
• Supply chain disruptions, national resilience policies, and higher wages are contributing to inflation.
• Central banks may be complacent about bringing down inflation due to biases towards preventing deflation.
• Historical episodes of high inflation often involved money printing by governments to fund debts.
• Slower globalization may reduce deflationary effects of international trade, contributing to higher inflation.

After decades of low inflation, prices are rising rapidly across the global economy. What explains this dramatic resurgence of inflation? Will it fade quickly or persist over the long term? Misguided policy choices and lack of vigilance allowing higher inflation to become entrenched?

The Spark: Stimulus in Response to COVID-19

The return of high inflation after 30-years of price stability can be attributed to the massive policy response to the COVID-19 pandemic. With economic activity severely depressed by lockdowns in 2020, governments provided enormous fiscal stimulus while central banks slashed interest rates to record lows and engaged in massive quantitative easing.

The scale of these interventions was unprecedented in the post-World War II era. The intention was to prevent a repeat of the Great Depression. However, the stimulus came just as activity was rebounding with the easing of lockdowns. The combination of surging demand and constrained supply was the initial impetus for rising inflation.

This monetary and fiscal stimulus was clearly disproportionate to the economic conditions at the time. Unlike the 1930s, there was no banking crisis or wave of bankruptcies. The policy bias was strongly influenced by fear of depression and deflation. Western policymakers were terrified of a repeat of the Great Depression. Because the declines in GDP that we were seeing in 2020 were on the same kind of scale.

So two things happened.

1. There was a tremendous loosening of fiscal policy.

Fiscal policy refers to government spending and taxation decisions that influence the economy. For example, increased government spending or reduced taxes can provide fiscal stimulus.

2. The central banks became fearful of the Great Depression, and loosened monetary policy on a scale that we really haven’t seen in decades.

Monetary policy refers to central bank actions that affect interest rates and the money supply. For example, lowering interest rates or increasing the money supply through quantitative easing provides monetary stimulus.

While defending fiscal stimulus as prudent for absorbing corporate and household debt, Central Banks went too far for too long in expanding the money supply and keeping rates near zero even as inflation picked up in 2021.

Why So Slow to Respond?

Despite signs of mounting inflation pressures, central banks were remarkably slow to reverse course. The Fed only began raising rates in March 2022, while the Bank of England did not start until December 2021. Institutional biases against inflation played a role in this complacency. Monetary policies like quantitative easing (QE) and flexible average inflation targeting were intended to lift inflation from undesirably low levels. But they had the unintended consequence of reducing vigilance against rising prices.

Quantative Easing (QE) in particular created a bias in bond markets by suppressing yields and discouraging bond investors from serving as an "early warning system for spotting inflation." The result was a failure to act quickly enough when inflation did reemerge.

There are also growing calls to raise inflation targets above 2%. But we must not change our view as to what is the acceptable inflation rate just when actual inflation is high, as it risks ratcheting up expectations.

The Role of Globalization and Geopolitics

While the pandemic stimulus triggered the inflationary surge, some long-run trends are also contributing to persistence. Globalization has provided deflationary impetus for decades as trade integration and offshoring cut costs. With globalization advancing more slowly or even shifting into reverse, these forces are fading.

Russia's invasion of Ukraine led to a spike in commodity prices. This adds a second leg to the story rather than being the original cause. Ongoing tensions between the US and China are part of a broader shift towards nationalism and supply chain localization. All these factors point to a more inflationary environment.

Warning from History

Looking back at historical cases of high inflation offers useful lessons on causes and consequences. The Roman Empire debasing coinage and the French Revolution's uncontrolled money printing are good examples. A common theme is governments resorting to inflationary financing because they cannot fund spending through taxes or cuts.

There parallels to today's high debt levels, saying: If you’re taxed up to the hilt, you can’t tax much more. You can’t cut other areas of spending very easily. You’re basically back to the default or the inflation options. With ageing populations boosting healthcare costs, pressure on government budgets will increase.

The broader message is that institutional safeguards like central bank independence can break down when inflation serves political ends. The idea that central banks and governments are independent from each other and remain independent forever, that’s not borne out by history.

Watch for Policy Mistakes

Looking ahead, the consensus view that inflation will quickly abate may well prove incorrect. If inflation does decline, it may require interest rates to remain higher than expected to achieve that outcome. Alternatively, rates may drop fast but at the cost of letting inflation persist above target.

To bring inflation down sustainably requires commitment and vigilance - resisting pressure to prematurely cut rates. Otherwise, inflation will ratchet higher in successive cycles. Complacency is a killer. In the 1970s inflation was initially seen as a manageable nuisance rather than the main threat. Now we know different.

Why Inflation Matters

Behind all the complex analysis, Inflation is profoundly undemocratic in its social impacts. Its arbitrary redistribution of income creates unfair winners and losers. It’s unfair and undemocratic. Many of us have forgotten what damage it can do.

That is the key lesson as Central Banks and governments navigate today's challenges: inflation may fade, but if handled poorly it could also persist - with damaging consequences for citizens and societies worldwide. Maintaining price stability should be the overriding priority.