How Stubborn Can Inflation Get This Year?

Inflation has been a global problem since last year. Ever since Covid-related lockdowns were lifted and people started buying goods and services just like in the days before Covid-19. Except that thanks to the lockdown, manufacturing facilities couldn’t ramp up production levels to meet the surging demand. Neither could shipping companies handle the surge in demand for ships and containers. This sent prices of almost all goods, higher. To add to the supply shortage, countries in East Asia that lead in global supplies of semiconductors were caught in the grip of a particularly vicious wave of Covid-19, with the delta variant. Inflation in services too was rising, as people returned to shops, restaurants, concerts and entertainment, as well as travelling.

We also have the war in Ukraine, which has taken its toll on the prices of energy, food and chemicals, the world over, as I wrote in a previous Owleye column. What we must remember is that thanks to the different ways inflation is playing out in different economies, they would grow at different speeds to recover from the post-pandemic years. Besides, it’s important to look at the causes of inflation. Supply chain issues which were the main cause of inflation since the end of 2021 are now improving. However, other problems persist to different extents across economies.

In the UK and Europe, which are now said to be in recession, high energy prices were the main culprit. This became more broad-based across other categories including food, alcohol and tobacco, and is now manifest as general inflation. What’s more thanks to the labour shortages in many sectors in the early months of economies reopening, wages were beginning to apply their own pressure as well. This is apparently still more persistent in UK and Europe, while in the US higher wage growth is only now beginning to ease, as was evident in the latest non-farm payroll numbers, when it came in lower than estimates. The latest consumer price inflation news from the US is that it has ticked down slightly, month on month and year on year, by 0.1% and 6.5% respectively, largely due to a fall in gasoline prices. Core CPI, though, increased month on month by 0.3% while slowing year on year to 5.7%.

What are the factors that can keep inflation entrenched and stubborn during this year and perhaps even the next? And what can be done about it?

First, and most obvious, is of course, the war in Ukraine. It is still raging and shows no signs of abating. Though the export of foodgrains from Ukraine continues under a special agreement, it is still below the levels the country used to export earlier, as the war takes its toll. The impact on energy prices is being felt most in Europe, and as long as governments subsidise the cost of energy to households, prices are unlikely to come down very much.

For the rest of the world too, the war being waged by Russia has its impact on oil prices. The only saving grace is that with central banks tightening interest rates, slower economic growth is expected and that means lower demand and prices for oil. OPEC has already indicated that it will keep oil production steady amid expectations of an economic slowdown in some parts of the world and recession in others.

However, with the latest news of China reopening its economy, demand might not stay low for very long. It will take China some time to control the Covid pandemic in the country as they try to grow the economy, but I think that by the second half of 2023, we could see demand for oil and other commodities start to rise again. This will, naturally, put upward pressure on prices once again.

Thanks to all the fiscal stimulus pumped into the economy in western countries during the first couple of years of the pandemic, households still have a comfortable cushion of savings accumulated. Spending then was restricted thanks to the pandemic, and people even felt comfortable turning down jobs. Now that jobs are being created at a good momentum in the US and other countries, people are back to spending on essentials and discretionary goods and services, including travel. Therefore, consumer demand led inflation could persist. Also, as the labour market tightens, the pressure will be back on higher wages.

This is where central banks’ actions are so important. In increasing interest rates and the cost of capital, the slowing down that they induce also helps to keep the demand for labour slightly weak. Much better to tolerate a little more unemployment – even temporarily – than to have inflation persist for years and wreak havoc in the economy.

However, things are very different in my country, India. Here, we have had high levels of unemployment for decades and with most of the employment in the informal or unorganized sector, high unemployment also means lower tax revenue for the government. In India, we have also had an economic slowdown much before the pandemic struck, and inflation that is proving to be quite stubborn. As I have been writing for quite some time, a lot of it is to do with the government keeping oil prices high through excise duties and taxes. It has filtered through to general inflation, of which core consumer price inflation has been stuck at around 6% for a few years. The fact that internationally oil prices are high and that our Indian rupee has weakened considerably against the dollar only make matters worse.

As the US aggressively raises interest rates to control inflation in the US, the US dollar strengthens even more against other currencies. This will adversely affect poor and developing countries that rely on a lot of imports, as their import bills are likely to balloon during this year and the next. This will act counter to what these countries’ central banks might be trying in order to control inflation, and we can expect inflation to be stubbornly high in such circumstances.

In India, for example, the weaker rupee and strong demand for commodities have worsened our current account deficit, from 2.2% in Q2 of FY23 to 4.4% in Q3 of FY23. According to the RBI, this is due to a worsening trade balance. This not only adds to inflation in the domestic economy, it makes our debt levels and servicing of it more unsustainable. And as we go through 2023, when the global economic slowdown will be even more accentuated, our exports are likely to weaken considerably as well.

Many countries including India ought to rein in imports, especially of non-oil, non-essential imports such as gold and other items. And central banks’ rate increases will also act as a dampener on imports by slowing down investment demand, while also slowing consumption demand. In addition, governments ought to consider fiscal measures to lower inflation as well and improve public finances, but will they? I was of the opinion that India ought to have raised taxes on the wealthy and on corporates during the pandemic, as a way to strengthen the nation’s coffers and to be able to spend more on Covid relief. Much better than keeping taxes on oil high, which is inflationary and affects the poor the most.

Even now as economies slow, governments will have to look at fiscal measures such as increasing taxes on the wealthy and the highest earners. Unfortunately, in countries which face important elections this year, or the next, the tendency will be to splurge on freebies and sops to the people, as often happens in India. Populist policies like these, at a time of serious economic slowdown could be the undoing of economies.

Inflation is considered a tax on the poor. They ought to be protected, through prudent and progressive taxation policies as well as central banks’ decisions to maintain price stability. I have already written recently on the higher fertilizer subsidy bill that this government had to incur last year as well as this year.

All in all, a slower chugging economy is what we will have to settle for in 2023. Under the present global circumstances, even that seems a luxury.       

The animated owl gif that forms the featured image and title of the Owleye column is by animatedimages.org and I am thankful to them.

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