People in the United States love big words. The financial crisis was known as the ‘Great Recession.’ In the same vein, the long and relatively positive period preceding the financial crisis is called the ‘Great Moderation’. And of course, there was the ‘Great Depression’ of the 1930s. To follow this logic, the current situation could be termed as the ‘Great Inflation’. After all, everything is big in America.
Typically, inflation is measured by the annual or, more precisely, the 12-month change in prices. If the prices remained at the current level without any future increase, inflation would fall to zero in 12 months. Optimally, inflation could fix itself. However, rising prices tend to create a spiral because high prices give rise to expectations and demands in all sectors to share the gains.
The roots of the inflation we are currently facing are diverse but extraordinary. Normally, inflation is caused by business cycles, a spiral created by low unemployment, rising expectations and wage increases that will eventually materialise. The current inflation can be traced back to Covid bottlenecks, geopolitics-inspired economic warfare and rising commodity prices, as well as the good old positive business cycle. Many people see the expansive economic and monetary policies pursued by central banks and governments as partly or chiefly responsible for the current situation.
Covid-driven inflation
The Covid-virus was about to be declared defeated in early 2022 when new geopolitical problems emerged. Last year a big talking point was the bottlenecks caused by Covid-19, affecting the companies’ ability to produce and deliver goods. After an incipient recovery from Covid, we saw a sharp increase in demand, accompanied by pressures to increase prices. Moreover, there has been a shortage of labour in several sectors, which has only augmented the inflationary pressures.
Commodity-driven inflation
Russia’s war of aggression was preceded by price rigging. By reducing natural gas deliveries in 2021, Russia was able to increase prices and export revenues. The same policy has been pursued ever since, in various forms. If supplies were increased, prices would fall. While there is shortage of the products, the quantities commercially available are sometimes fine-tuned to keep prices sufficiently high.
Other commodity prices in the energy market have risen as well. Wheat is a pawn in the geopolitical game, but the prices of many metals are also increasing. One might think that speculative investor interest in commodities drives up prices even further.
Business cycle inflation
In the United States, inflation is partly driven by the existing business cycle. Unemployment is record-low, and wages are increasing at an accelerating pace. The same holds for the United Kingdom. In the euro area, the economic situation is reasonably positive, and unemployment remains low, but wage inflation has not yet raised its head to any noticeable extent. However, inflation figures vary considerably from country to country.
An expansionary economic and monetary policy combined with growing sovereign debt and Covid-related restrictions resulted in extra savings and deposits. People have saved a lot of money, which is expected to be spent on consumer goods. Now the dam has burst, and the money is gradually being channelled into the marketplace, thereby mounting pressures to increase prices.
How to bring inflation under control?
The key question now is how to bring inflation under control? There are three conceivable recipes for this. One is conventional, one personalised and one familiar to us from previous years.
1. Compromise by central banks
Central banks are between a rock and a hard place. With the inflation galloping at 5 to 10 per cent, they are expected to take action – and they are doing so. The policy they will adopt will probably be one of compromise, given the pressures they are under. They need to do enough but not too much, knowing that their actions will hinder economic growth more than slow down inflation. The central banks can communicate vigorously and hope that external developments will help press down inflation.
2. Putin and raw material
Much of the recent inflation stems from Putin's geopolitical war mentality. Russia is fighting on all fronts, and one theatre of war is raw materials and prices. Raw materials can be used to wreak havoc in a very short time indeed. Of course, it doesn’t work in the long term because all operators find ways to discard expensive products and replace them with cheaper ones. However, as we have seen, it is easy to create a short-term shock with commodities. Sooner or later, the high prices will collapse. The current price levels can be traced back to Putin, who apparently remains a key player in this respect.
3. Restrictions
If none of the above developments succeed in curbing inflation, it will probably be necessary to introduce restrictions. Many expect the next winter to be cold. What may make it even colder is the availability of energy in sufficient quantities and the foreseen increases in the price of oil and gas. This may compel governments to impose unpopular heavy restrictions in terms of quantities and prices. While these may clash with the spirit of a market economy, a state of war cannot be considered something normal. We in the western countries have already become accustomed to emergency conditions and constraints necessitated by Covid.
International investment banks are predicting falling inflation figures for the second half of this year. Lower inflation figures would, if those become a reality, bring long term interest rates down and bring momentary optimism. There won’t be many to resist that.
In conclusion
The ways of tackling inflation are complex and painful. The first-level solutions mean the traditional tussle between inflation and economic cycles. The second-level solutions consist of geopolitical scenarios related to Russia, and therefore it is probably pointless to speculate about them because whatever predictions are made regarding Russia, they invariably fail to hit the mark. The third-level solution is offered by restrictions. It is high time to start making plans because the winter is approaching fast.
The writer is VER's CEO Timo Löyttyniemi.
