Inflation has risen in the Eurozone in recent months, but there is little consensus on whether Europe is heading for a persistent rise in inflation as countries emerge from the pandemic. Markus Demary and Michael Hüther write that central banks may nevertheless face a dilemma over whether to take action if inflation rises further

Demary, Markus

Hüther, Michael

English

LSE Research Online

Should	central	banks	be	worried	about	risinginflation?Inflation	has	risen	in	the	Eurozone	in	recent	months,	but	there	is	little	consensus	on	whether	Europe	is	heading	fora	persistent	rise	in	inflation	as	countries	emerge	from	the	pandemic.	Markus	Demary	and	Michael	Hüther	writethat	central	banks	may	nevertheless	face	a	dilemma	over	whether	to	take	action	if	inflation	rises	further.When	inflation	is	going	to	rise,	economists	first	look	at	the	underlying	factors	and	whether	these	lead	to	a	transitoryincrease	in	inflation	or	a	persistent	one.	While	transitory	factors	usually	do	not	demand	central	bank	responses,persistent	factors	demand	monetary	policy	to	lean	against	rising	price	pressures.	Since	the	Covid-19	pandemic	haseffects	on	the	supply-side	as	well	as	the	demand-side	of	the	economy,	one	has	to	analyse	whether	these	effectsare	of	a	transitory	or	of	a	persistent	nature.Pent-up	household	savingsThe	saving	rates	of	the	household	sector	increased	sharply	in	many	countries	as	the	pandemic	broke	out	andhouseholds	either	refused	to	consume	goods	and	services	in	public	or	were	hindered	from	doing	so	because	oflockdown	measures.	The	higher	saving	rates	could	be	seen	already	in	the	first	quarter	of	2020.	The	life-cycleincome	hypothesis	from	Franco	Modigliani	states	that	permanent	income	is	used	by	households	for	permanentconsumption,	while	transitory	income	will	be	saved.In	this	case,	the	pandemic	and	the	lockdowns	have	decreased	the	permanent	consumption	of	households,	likeexpenditures	for	holiday	travel,	restaurant	visits	and	concerts,	leading	to	transitory	savings	which	havestrengthened	the	balance	sheets	of	many	households.	Thus,	the	willingness	to	pay	for	travel,	restaurant	visits,	andconcerts	has	increased,	making	it	possible	for	companies	in	these	sectors	to	increase	prices.	This	has	led	to	ahigher	price	level	but	only	to	a	transitory	increase	in	the	inflation	rate.The	effects	of	short-term	workA	short-term	work	system	was	successfully	implemented	by	Germany	during	the	financial	crisis	and	has	beenapplied	across	Europe	during	the	Covid-19-crisis.	Under	this	system,	businesses	can	temporarily	cut	the	hours	oftheir	employees	with	the	government	compensating	workers	financially	for	their	lost	earnings.	The	advantage	ofshort-term	work	is	that	it	lessens	the	pressures	for	companies	to	lay	off	workers	during	a	recession	and	it	thereforereduces	their	hiring	costs	during	the	recovery	phase.	Moreover,	short-term	work	prevents	the	destruction	oforganisational	capital	during	recessions.Without	short-term	work,	companies	would	have	to	lay	off	workers	during	a	recession	and	they	would	have	tocompete	for	new	workers	in	the	recovery	phase,	thereby	pushing	up	wages.	Moreover,	companies	would	have	toincrease	the	prices	of	their	goods	and	services	in	order	to	compensate	for	these	higher	labour	costs.	This	higherwage	growth	would	give	workers	more	financial	space	to	increase	their	demands,	causing	inflation	to	pick	up,leading	them	to	demand	further	wage	rises	to	compensate	for	higher	inflation.	This	price-wage-spiral	can	then	leadto	permanently	higher	inflation.	However,	in	the	case	of	the	Covid-19	crisis,	the	application	of	short-term	work	hasreduced	the	potential	for	such	price-wage-spirals	during	the	recovery	phase	and	this	makes	high	permanentinflation	less	likely.The	effects	of	government	spendingLawrence	Summers	and	Olivier	Blanchard	expect	US	government	spending	to	lead	to	an	overheating	economy.Governments	in	all	pandemic-hit	countries	had	to	increase	spending,	which	raises	the	question	of	overheating	andinflation.	Thomas	Sargent,	in	his	classic	study	of	four	countries	that	experienced	dramatic	periods	of	inflation,suggests	that	persistently	large	deficits	lead	to	inflation,	and	that	previous	inflationary	episodes	have	ended	withbudgetary	reforms.	The	question	is	whether	Sargent’s	results	also	apply	to	the	current	situation.LSE European Politics and Policy (EUROPP) Blog: Should central banks be worried about rising inflation? Page 1 of 2		Date originally posted: 2021-05-03Permalink: https://blogs.lse.ac.uk/europpblog/2021/05/03/should-central-banks-be-worried-about-rising-inflation/Blog homepage: https://blogs.lse.ac.uk/europpblog/Although	the	current	crisis	is	extraordinary,	the	pandemic-induced	demand	shock	and	the	lockdown-induced	supplyshock	are	of	a	temporary	nature.	Once	the	pandemic	has	ended,	households	will	travel	and	visit	concerts	andrestaurants,	and	companies	will	supply	goods	and	services	again.	Government	spending	is	needed	to	preventbusinesses	running	into	insolvency	and	to	support	workers	who	have	lost	their	jobs.	Other	measures	are	intendedto	increase	demand,	like	the	temporary	tax-cuts	in	Germany.	For	the	US,	there	is	evidence	from	Olivier	Armantierand	his	co-authors	that	households	used	their	consumption	checks	mainly	for	saving	and	debt	reduction	rather	thanfor	consumption,	which	stands	in	contrast	to	the	overheating	hypothesis.The	effects	of	debt-deleveragingAs	stated	above,	companies	raise	debt	for	covering	costs	rather	than	investing.	We	(alongside	our	co-author	StefanHasenclever)	have	previously	argued	that	the	pandemic	thereby	leads	to	a	deterioration	in	the	balance	sheetquality	of	these	companies,	thereby	restricting	their	future	access	to	finance.	Thus,	before	companies	startinvesting,	they	have	to	restore	their	equity	capital	buffers	and	their	liquidity	buffers	by	saving.	If	too	manycompanies	are	involved	in	a	debt	deleveraging	process,	the	economy	might	get	into	a	situation	of	a	demandshortage,	which	will	lead	to	low	inflation	or	mild	deflation.The	prospect	for	oil	pricesThe	price	of	oil	has	a	very	important	influence	on	the	future	path	of	inflation.	First,	it	determines	the	price	of	fuel	forcars	or	for	heating.	Second,	it	determines	the	price	of	plastics,	which	are	fundamental	to	many	products.	Thereby,rising	oil	prices	could	have	second	round	effects	on	core	inflation.The	oil	price	experienced	a	pandemic-induced	decline	as	many	people	either	worked	from	home	or	walked/cycledinstead	of	using	public	transport.	While	mobility	declined	to	a	greater	extent	during	the	first	lockdown	than	duringthe	second	one,	oil	prices	have	recovered	from	the	low	they	hit	in	April	last	year.	There	is	still	a	lack	of	demand	forkerosene	because	of	travel	restrictions.	However,	demand	for	kerosene	might	increase	as	travel	restrictions	arerelaxed.	As	soon	as	the	oil	price	increases,	inflation	will	also	go	up	again.A	dilemma	for	central	banks?Given	all	the	factors	discussed	above,	predictions	for	inflation	are	highly	uncertain,	and	higher	inflation	cannot	becompletely	ruled	out.	If	inflation	rates	rise	to	say	four	percent,	central	banks	will	have	to	step	in.	This	raises	adilemma	for	central	banks	because	the	fight	against	inflation	will	lead	to	higher	financing	costs,	slowing	theeconomy	and	hindering	companies	from	reducing	their	Covid-19	legacy	loans.Hindering	the	restructuring	of	balance	sheets	will	lead	to	lower	future	investment	demand	and	contribute	to	lowinflation	in	the	future.	Thus,	the	options	for	central	banks	are,	first,	fighting	possible	transitory	inflation	now	at	thecost	of	running	into	low	investment	and	low	inflation	in	the	future,	and	second,	accepting	higher	transitory	inflationnow	with	the	aim	of	fostering	a	recovery	in	corporate	balance	sheets	and	stable	inflation	in	the	future.Since	today’s	inflation	spike	is	due	to	transitory	factors,	the	second	option	will	be	the	better	one.	However,	it	will	bepolitically	more	controversial	because	central	banks	have	to	keep	interest	rates	low	in	times	of	inflation	exceedingtheir	inflation	targets.	We	do	not	expect	any	trade-offs	for	central	banks	between	fighting	inflation	and	supportingeconomies	to	grow	and	to	deleverage.	Instead,	we	see	a	welcome	return	of	inflation	towards	its	target	value.For	more	information,	see	the	authors’	accompanying	paper	published	by	the	Institut	der	deutschenWirtschaft	(IW)Note:	This	article	gives	the	views	of	the	authors,	not	the	position	of	EUROPP	–	European	Politics	and	Policy	or	theLondon	School	of	Economics.	Featured	image	credit:	Martin	Lamberts/ECB	(CC	BY-NC-ND	2.0)LSE European Politics and Policy (EUROPP) Blog: Should central banks be worried about rising inflation? Page 2 of 2		Date originally posted: 2021-05-03Permalink: https://blogs.lse.ac.uk/europpblog/2021/05/03/should-central-banks-be-worried-about-rising-inflation/Blog homepage: https://blogs.lse.ac.uk/europpblog/

Should central banks be worried about rising inflation?

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Should central banks be worried about rising inflation?

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