Societies around the world as well as the economic staffs of governments must be prepared for the possibility of revivals on the inflation front. Inflation, after reaching its highest level in decades in mid-2022, in the United States and the euro zone, fell sharply in the second half of last year.
But in December, the nominal consumer price index (CPI) in the US and the harmonized index of consumer prices (HICP) in the euro area rose slightly.
The speed of deflation last year surprised many, not least central banks, which insisted it was too early to declare victory. Have officials been dovish because they believe there is persistent underlying inflationary pressure, which can explain the recent uptick, or have they simply surrendered to uncertainty?
Markets appear to be embracing the latter explanation, expecting both the US Federal Reserve and the European Central Bank to begin cutting interest rates in the spring. The figures show a persistent decline, regardless of the recent (small) increase. More specifically,
if we look at the percentage change in core inflation over the last six months (year-on-year) – a more timely indicator of core inflation than the 12-month change – both the US and the eurozone have brought inflation back to the 2% target.
This means that price stability may well be restored within three years, which by most definitions would make the last period of inflation “transient”.
Monetary policy is a powerful tool and it is what ultimately reduces inflation. That’s why central banks are often encouraged to start tightening immediately: if they don’t intervene quickly and decisively, expectations can become “unfounded”, fueling a wage-price spiral that leads, de facto, to job losses. This happened in the 1970s.
However, aggressive deflation comes at a cost, and easing inflation can undermine economic growth and financial sector performance.
The details depend in part on the factors driving inflation: if the culprit is an uneven supply shock (associated with large relative changes in prices), the cost of deflation is likely to be higher than if the cause is increase in aggregate demand.
This brings us to the last period of inflation. In the eurozone, it was probably mainly due to uneven energy and supply shocks, which gradually spread through economic sectors – starting with manufacturing and then moving to services. This was probably also the case in the US, but to a lesser extent.
In both economies, wage ‘coverage’ pressure was moderate, with no sign of a wage-price spiral. And, during the deflationary phase, the labor market did not weaken significantly in the US or Europe. In other words, both inflation and deflation occurred in goods markets, not labor markets.
This interpretation is supported by the fact that although the decline in core inflation (which strips out volatile food and energy prices) has lagged behind the decline in headline inflation, structural inflation is now converging on the 2% target.
This surprisingly sharp decline occurred before economic activity began to soften (probably as a result of monetary tightening). According to Eurostat, quarterly GDP growth in Germany was zero in the second and third quarters of 2023 and is now estimated to have fallen to -0.3%. The Eurozone average fared slightly better with no growth in the fourth quarter after -0.1% in the third quarter.
Demand for bank loans, according to the ECB’s bank lending survey, is now weaker than during the 2011 sovereign debt crisis.
The energy transition is underway, so increases in energy demand may well run into supply constraints, which are even more likely to intensify amid rising geopolitical tensions.
Central banks should consider, in the face of uneven supply shocks, giving themselves more time to bring inflation back to target. Ultimately, the standard prescription of aggressive monetary policy tightening – which works by squeezing aggregate demand – will prove less effective in containing inflation caused by uneven supply-side shocks. And it will come at a high cost.
In addition to undermining financial stability and employment, excessive tightening prevents relative price adjustment, thereby reducing the efficiency of resource allocation.
If monetary conditions remain tight for an extended period, investors may be discouraged from pursuing long-term investments such as those made in green technology. In short, when inflation is due to supply constraints, monetary tightening alone is not the answer. Fiscal policy action – and monetary and fiscal coordination – will also be needed.
A persistent Ιnflation period has a double barrel impact:
- For various reasons, stock prices is going to depressed if the inflation continue to be persistent. Only when the level of inflation wil drop substantially the business prospects will improve.
- the second impact of inflation is to cause current replacement costs of assets to be substantially higher than their recording historical book values.
These twin effects will resulted in decline of the q-ratio of the companies (the q-ratio is defined as the ratio of the market value of the firm shares to the replacement costs of the assets represented by those shares). If the q-ratio of a company is less than 1, and this company wish to add to capacity in producing a particular product, it could acquire the additional capacity more cheaply by buying a company that produces the product rather than building brick and mortar from scratch. In that case-of a persistent inflatio period, we have to expect a wave of Mergers & Acquisitions between companies in the same but also in different industries. The new companiew that will appear after the M&A process, will reduce the human resources causing increase in the unemployment through the replacement of employees with Artificial intelligence units.
