By Lena Faucher and Satyam Anand
While 2021 was marked by unpredictable fluctuations in the economy, the first quarter of 2022 has not shown any signs of a return to ‘business as usual’. Across the world, private and public sectors are worried not only by the surge of Covid cases, but also by the rise of another threat : inflation. With consumer prices going up by 4.9% in Europe and a staggering 6.8% in the United States, governments and consumers are increasingly preoccupied by the future of the economy and the consequences on their daily lives.
So what exactly caused this inflation? As macroeconomics textbooks would explain, central banks are responsible for managing two key indicators: inflation and unemployment. Once COVID-19 attained pandemic status earlier in 2020, the world economy crashed as companies scrambled to reduce their overhead primarily through laying off their employees, scaling back expansion projects and postponing inventory purchases. High uncertainty about remote working capability and long-term solutions such as the efficacy of the vaccine against new variants contributed to fears of prolonged recession as markets plummeted globally.
However, having learned their lessons from the Financial Crisis of 2008-2009, governments and central banks engaged proactively in providing stimulus packages and once again reducing interest rates to their zero-lower bound. By bolstering consumer confidence and encouraging borrowing, these governmental programs contributed to rising demand across the economy. Despite successive lockdowns, consumers shifted their spending towards home improvement and high-tech goods. As summer arrived, widespread vaccination particularly in Europe and the United States resulted in a brief recovery over the summer of 2021 where families returned to restaurants, beaches, concerts and other public venues once again.
Unfortunately, although the stimulus created the desired rebound in demand, manufacturers further upstream remained unable to match this resurgence in orders. The shortage of staff and material, resulting from sudden halt of production lines, indeed created massive disruptions and delays at all stages of the global supply chain. As companies ordered additional stock to increase inventories as a form of insurance against possible future lockdowns, these supply chain problems were further exacerbated. Likewise, ports and harbors remain under-staffed and under-equipped to handle the sudden influx in shipping freights that has created a shipping container shortage. These difficulties in procurement upstream propagate downstream as inflationary ripples. Demand remains high as consumers fulfill postponed purchases with their savings accumulated from the lack of discretionary spending during earlier lockdowns, allowing companies to off-load the increasing manufacturing and logistics costs onto their end-users.
Furthermore, the increased focus on remote working as well as playing video games during lockdowns has shifted household consumption towards the technology sector. Yet silicon production remains behind schedule, creating a shortage of semiconductors which has caused shortfalls in automobile to high-tech device production. With fewer cars being produced, the American automobile market has been experiencing a consumer frenzy for both new and second-hand vehicles. While new car prices have increased by only 5%, used cars are now selling at prices 45% higher than last year. For instance, a student at the Graduate Institute proudly discussed how she managed to sell her 2014 Honda Civic for almost its sticker price before moving to Geneva from the United States. This willingness to keep buying despite sky-rocketing prices therefore feeds into the inflation cycles across the West.
As some consumers are postponing their purchase of non-essential goods, the surge in oil prices in the United States and Europe is primarily hitting poorer households. Although the Biden administration has considered releasing some of its strategic oil resources, oil prices have reached $3.50 a gallon, a seven year high in the United States. This number is expected to remain high and even keep rising well into 2022, fueling inflationary pressures across sectors. Across the Atlantic, Europe’s dependence on Russia for natural gas combined with diplomatic tensions over Ukraine have imposed an extra financial burden to consumers. With temperatures getting colder, Europeans are struggling to stomach the 800% increase in natural gas prices over 2021. Although Moscow has come under fire for manipulating prices, the recent closure of a number of nuclear plants in France and Germany should also be taken into account for explaining these evolutions.
So what can governments in the US and Europe do to curb inflationary pressures?
Having established the underlying causes behind this alarming inflationary spiral, let’s discuss how exactly the Federal Reserve and central banks aim to tackle this challenge. Approaches vary tremendously depending on the national context and expectations surrounding the current Omicron outbreak and any subsequent mutations. Central banks must balance the fallout from increasing inflationary pressure due to inaction against the risk associated with prematurely repealing economic support systems that may exacerbate unemployment and other issues.
For instance, South Korea has embraced contractionary policies to aggressively quel rising prices as the Bank of Korea raised interest rates following its government’s decision to end its stimulus programme. Contrastingly, although Switzerland has only undergone mild inflation at around 1.2%, its central banks may follow the lead from the Federal Reserve and European Central Bank to ensure Swiss assets remain appealing to foreign investors.
And what are their intentions? The Federal Reserve has adopted a more cautionary stance towards inflation than earlier and acknowledged its intention to curtail the stimulus programme shortly and, if needed, gradually raise interest rates thrice in the upcoming year. This marks a deviation from the prior rhetoric that viewed inflation as a ‘transitory’ evil. Since the United States employment has largely recovered whereas inflation has reached heights previously seen almost half a century ago, the Fed believes that this may be the moment to adjust its stance and scale back its programmes propping up the economy.
The same cannot be said for the European Central Bank: whereas eurozone inflation has reached its own record highs at 5%, the unemployment rates across its Member States remain precarious. Although these concerns have caused the Central Bank to curtail its asset purchasing programme, it promises to continue stimulus provisions in the upcoming year. Furthermore, rather than raising interest rates in 2022, Christine Lagarde aims to introduce the first interest rate in spring 2023 to allow European businesses additional time to recover. Unlike the United States, European countries in general have limited fiscal maneuverability and rely on support from their central banks to ensure stability across the region. Crucially, both these institutions remain flexible in their approaches to accommodate any lingering concerns about possible deterioration in public safety with respect to the pandemic.
Lena Faucher is a fourth-year student in the Dual Bachelor between Sciences Po and the University of British Columbia. After having specialized in economics and finance in Sciences Po, Lena is now completing an International Relations major at UBC. She is particularly interested in European foreign policy, political economy and more recently in sustainable economics. She wishes to pursue a master’s degree in international relations and/or economics.
Satyam Anand is a graduate student in the Economics department at the Graduate Institute, Geneva. When he is not busy coding, he writes articles about economic policy and financial markets for the Graduate Press.
This piece is part of a series in collaboration between the Graduate Press and The Paris Globalist, the global affairs magazine of SciencePo Paris.
Image from: Unsplash.com
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