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Soaring prices caused by low levels of supply and sudden demand have driven inflation from the near-zero levels it has enjoyed for almost a decade to 7% in the past 12 months. The perfect storm of abnormally tight supply chains under pressure from the side effects of the pandemic has pushed prices up in a way that economists say ushered in unconventional markets where inflation is driven by supply. instead of the usual request. The result could be greater volatility ahead as the global economy heads for recovery.
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Inflation has historically (until now) been demand driven. According to economists, the current picture of what causes inflation today is supply, but it’s a bit more complicated than that.
In a new report from Blackrock, economists say past episodes of inflation were driven by economy-wide demand that was “unusually warm”. This can mean that there is creeping demand, fueled by both economic growth and an increase in jobs, followed by a desire to spend more money across all sectors.
A very complicated supply chain
Right now, they argue, supply bottlenecks are causing upward pressure on prices. And from a political point of view, this complicates matters. In the case of more normal, demand-driven inflation, the easy answer is an increase in interest rates to generally “cool” the economy and dampen overall spending. When inflation is supply-driven at a time when the economy is not yet fully up to speed, the answer is not so simple.
Using data from the Bureau of Labor Statistics and the Blackrock Investment Institute, the investment firm shows that the US economy is still below pre-pandemic projections for US GDP. With the economy not yet operating at full capacity and inflation largely driven by supply, Blackrock says central banks are faced with a tough decision: “either live with higher inflation or destroy inflation.” ‘activity before reaching full capacity’.
While the economy has largely improved, the labor market still has millions fewer jobs than it did in February 2020. “Destroying activity” would mean raising interest rates to a rate suppressive enough to bring prices down sufficiently to a sustainable level. It would simultaneously crush growth at a time when the economy desperately needs it. The riddle is a riddle that has never been seen before, and central bankers’ answers are likely to be just as unique.
The government’s ideal response
Blackrock’s suggestion is that the government should overcome current inflationary pressures for now. They recommend raising interest rates gradually to return to more neutral levels, but not so much as to prevent growth.
Macroeconomic policy strategist and founder of Ziemba Insights, Rachel Ziemba also agrees that monetary normalization, or a shift from “excessive stimulus to more normal conditions” is necessary, but only part of the answer. Ziemba told GOBankingRates, “Central banks should withdraw some liquidity and stop super-accommodative policies, but other parts of government need to encourage more production and do better to encourage supply chains. That means also reset expectations for inflation and growth “so we don’t try to get back to historic levels of low inflation.”
She adds that trying to use the blunt tools of too many interest rate hikes would likely stunt growth and lead to another recession. Focusing on improving the quality of growth, rather than just focusing on increasing growth markers, is crucial, she says.
A new way forward
This new “macro” normal could mean living with supply-driven inflation, which means governments may have to learn to live with this kind of inflation in order to dampen growth volatility, Blackrock says.
Ziemba suggests that some ways to address these issues could include selectively reducing tariffs and supply restrictions, and investing in infrastructure to spur potential growth, which will increase capacity and attract more people to the job market. . By focusing on production in the United States, the economy can be less dependent on international supply chain constraints while simultaneously putting more Americans to work.
Spending on it could temporarily raise inflation, but it could also pay off big in the future if supply-driven inflation is the new way forward. Blackrock mentions that prices tend to rise faster “in response to bottlenecks than they tend to fall in response to spare capacity” and that this has pushed inflation higher even though activity global economy has not fully recovered. If higher production were done on US soil, it could help avoid some of those price gauges.
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Possible risks for investors
For investors, the biggest risk Blackrock sees is that rate hikes by central banks will fuel inflation expectations. This would be bad for bonds and stocks, as higher interest rates would slow overall growth. The result would be to see markets move as they normally do and react to market downturns. The risk is that if the central bank decides to back down, for example, if it realizes that it raised rates too high too soon and hurt growth too much, it will have to cut rates of interest. Since investors will already be priced into previous higher rate levels, investors stand to lose money depending on where they are valued prior to a reversal. Greater macro volatility in growth and inflation will imply higher premiums on bonds and equities, the investment firm adds.
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