Since the first few months of 2021, inflation rates have started to spike significantly worldwide, and this rise has become evident since the second quarter of this year. Although the reasons behind the exacerbation of inflation are quite clear, the prospects for this phenomenon and the extent of its persistence within the world economies remain disputable and uncertain, which sets the course of the global economy during 2022 in question.
Steady rise
The rate of increase in the consumer price index accelerated in the developed and developing countries during 2021, which was particularly evident in the second quarter of this year, and which continued during the third and fourth quarters. In advanced economies, the average annual inflation during the second and third quarters of 2021 was about 4% in OECD countries and 5.1% in the US, versus 2.1% and 1.8%, respectively during 2019 prior to COVID-19 pandemic.
In developing countries, the average annual inflation during the same period in 2021 was about 6%, compared to an average of 4% in 2019, for a group of 45 countries, with the exception of Lebanon due to particular circumstances that it is going through, and which are causing excessive inflation rates.
Compound causes
The rise in inflation in the world during 2021 is due to a number of complex reasons of different nature, some of which pertain to the real economy (production activities, labor market developments, etc.), as well as others pertaining to the monetary sector (i.e. the extended implications of monetary policies adopted by central banks in some countries) . The key reasons for the rise in inflation can be identified in the following points:
1- The acceleration of demand for goods with no acceleration of supply: In its onset, the COVID-19 pandemic caused a sharp and sudden drop in the demand of companies and factories for materials and intermediate goods. This was due to the prevalent uncertainty about the prospects for economic activity in the world. With the beginning of 2021, and in light of the acceleration of vaccination programs to counter COVID-19, as well as the gradual return of life to normal, this demand quickly revived, and producers found themselves incapable of increasing their supply at a parallel speed.
2- The existence of logistical crises: The logistics sector in the world faced severe turbulence, as the rapid increase in demand for goods and services did not give shipping networks, containers and ships sufficient time to keep pace with its speed. The labor market has been severely impacted by the COVID-19 pandemic, and the disruptions in major ports and trade routes in the world have exacerbated this problem, including restrictions imposed in the ports of the Pearl River Delta in Southern China’s Guangdong Province, as well as congestion and overcrowding in the ports of Long Beach and Los Angeles in US and pressure on distribution centers and warehouses.
The disruption of commodities in global trade paths and the faltering of supply chains have intensified the imbalance between heavy-moving supply and the accelerating demand, specifically with most companies relying for decades on methods of reducing their inventories by using what is known as just in time (JIT) production methods. These methods rely on reducing costs by ordering inputs and intermediate goods once they are actually needed without accumulating them in advance. This made companies face a shortage of stock and production inputs, which caused the supply to be constrained even more.
The Baltic Dry Index - which measures the change in the cost of transporting raw materials and shipping goods - has risen to record levels, an annual increase of about 650% in May 2021. Although the index was relatively calm in late November, it is still at relatively high levels compared to the periods preceding the COVID-19 pandemic.
3- Rising energy prices: The spikes in energy prices led to a rise in the inflation index, chiefly in European countries, where the European Central Bank indicated that the rise in oil prices in particular resulted in high inflation rates recently, specifically with the unfavorable impact caused by the collapse of prices of crude oil during the COVID-19 epidemic, Energy constituted 2.2% of the total inflation rate in Europe during October 2021, which exceeded 4%, in addition to other factors such as the expiration of certain tax exemptions, including the temporary exemption of value-added tax in Germany.
4- Monetary policies during the COVID-19 crisis: A team of economists believes that the massive liquidity pumped by major central banks around the world at the peak of the COVID-19 pandemic, in avoidance of a recession, has found its way into prices. Fiscal stimulus packages, as well as asset purchase programs with zero monetary interest, may result in an increase in inflation rates. However, this hypothesis is disputable, since it is based on the fact that the quantitative easing programs carried out by major central banks in the wake of the global financial crisis did not necessarily lead to an increase in inflation rates.
According to a report by the IMF, studies indicate that the expansion of reserve money (M0), which results from asset purchase programs, does not automatically cause a large and continuous rise in inflation, particularly when it is preceded by low inflation records, and when the parties of the economic community receive it as a response to effect economic stabilization, not as a response to a pressing fiscal deficit. Therefore, quantitative easing programs may not necessarily be associated with a continuous rise in inflation. The situation actually depends on several other factors that determine the extent to which banks translate the increase in their surplus cash reserves into broader lending and greater availability of liquidity in the economy in general
Temporary or continuous inflation?
Those concerned with economic affairs are divided into two groups with respect to the future of the global economy and the phenomenon of inflation in particular. To understand this divergence, it must be made clear that inflation cannot be viewed from one angle in all cases. There are three different scenarios of inflation, which can be portrayed as follows:
1- The first scenario is the rate of inflation required to keep economic activity in a state of expansion, when it is moderate, stable, and most importantly, expected. Major central banks (such as the US Federal Reserve) usually try to keep the long-term inflation rate at 2%.
2- The second scenario is inflation, which results from a negative shock on the supply in most cases, since obstruction of economic activity generally raises prices, including energy prices. In this case, central banks do not prefer to rush into contractionary policies with a hasty interest rate hike, since this may cause the problem to extend and deepen into a prolonged depression, prompting monetary policy makers to look beyond inflation rates.
3- The third scenario, which raises everyone's concerns, is when inflation, regardless of its cause, causes inflation expectations by various parties in the economic field to unravel. When expectations of high inflation prevail, the parties of the economic community act on the basis of these expectations, causing inflation to actually take place. In other words, when everyone expects high inflation, producers actually start pricing their products on that basis, and people start requesting a raise in their salaries, so high inflation actually continues as a sort of self-fulfilling prophecy.
The current dispute can be summarized as follows: A group believes that we are still in the second scenario, and that inflation is temporary and is linked only to temporary shocks on the supply side. Another group sees that we are heading towards the third scenario, and talks a lot about a period similar to the stagflation experienced during the seventies of last century.
Upcoming concerns
By observing the given information, we may see that the global inflation scene is not without an underlying risk, but the matter is unlikely to exacerbate for years, as was the case in the seventies. So, arguably we have not passed the second inflation scenario yet, but the situation requires intense and urgent measures by monetary policy makers around the world in order to rule out slipping into the third scenario.
In terms of concerns, the supply chain bottlenecks may take some time to dissipate, particularly in light of some warnings regarding the exacerbation of the crisis of locating workers in the shipping and maritime transport sectors, since the harsh conditions experienced by this sector may result in the lack of workers, or their demand for high wages.
However, the grave risk lies in inflation expectations, which have risen significantly and persistently in the US since the beginning of 2021, represented by the 10-year inflation breakeven point, which amounted to an average of 2.37% during 2021, compared to 1.74% in 2019 prior to the COVID-19 pandemic, which is the rate that is seen as an indicator of inflation expectations in the US debt instruments market. This rise in itself represents a risk that the US Federal Reserve in particular, and central banks in general, must look at with great prudence.
In short, despite the indications of high inflation expectations mentioned in 2021, this is still all about the objectives of central banks in developed markets, which can still manage inflation rates through their instruments. Thus, it is believed that the US Federal Reserve will stick to its role in managing inflation expectations, accelerating the monetary tightening measures. This was proven by the US Federal Reserve deciding in its mid-December 2021 meeting to double the speed of reducing the asset purchase program, a step which was expected. It also suggested the possibility of raising the interest rate within 2022 about three times, by 25 basis points at a time. Meanwhile, the Bank of England has raised interest rates by 25 basis points, spurred by inflation concerns, and ignoring the Omicron virus concerns in the UK.
However, the biggest concerns for inflation in 2022 seem to be about emerging markets, which will suffer from the implications of global inflation on the one hand, or from the endeavors to contain it on the other. Assuming that major central banks take a more rapid approach to containing inflation and managing its expectations, this will impact the value of emerging market currencies, which will make the inflation wave more intense and longer lasting in several countries compared to others.
