Six years ago I wrote an article (and I apologize for the self-quotation) in which I asked myself why inflation was not higher after years of efforts by central banks to increase it. I have gone through the short list of causes from back then and it sheds some light on the current situation and possible solutions. Inflation was then low because of the continued fall in commodity prices and now it is high because we are experiencing the opposite situation. In part due to the dislocation caused by the pandemic and more recently by the invasion of Ukraine.
In 2016, inflation was persistently low due to the chronic weakness in demand, due to the debt load that had caused the great financial crisis. Today, the situation has been reversed and the stimuli linked to covid, plus unspent income during the pandemic, generate strong demand that puts pressure on a supply that is unable to respond.
Another factor that limited the increase in prices in the past decade was the anti-inflationary credibility of the central banks, which had managed with many years and efforts to anchor society’s inflation expectations at low levels. Low inflation was even a danger since at times there was fear of deflation. Today we are at risk of expectations being revised upwards and being incorporated into many business and labor contracts. If this happens, the higher inflation we are now experiencing will become structural inflation.
Finally, and most importantly, what is happening vindicates the famous Nobel laureate Milton Friedman, when he stated that inflation is always and everywhere a monetary phenomenon. After the great financial crisis this idea seemed obsolete. The reality is that the fragility of the financial system and the deteriorated balance sheets of families and companies prevented the extraordinary monetary impulses of that time from reaching the real economy. Today there is no obstacle and these exceptionally easy monetary policies act as firewood that fuels the inflationary sparks caused by the rise in raw materials.
Inflation will not be broken by price controls, which only distort markets and cause shortages. Neither the subsidies, which feed the public debt and are bread for today and hunger for tomorrow. It is true that an income pact that fairly distributes the unavoidable loss of purchasing power will make inflation less harmful, but it will not defeat it. The genie of inflation has definitely come out of the bottle, and I am very much afraid that bending it will only be possible with a substantial dose of financial restraint. Excessive liquidity has ended up generating inflation and the only solution to redirect the problem and the expectations of agents and financial markets is to reduce the excess money that floods our economies.
Jordi Gual is a professor at IESE
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