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Rising inflation – supply and demand influences
Our analysis suggests a significant role for demand effects, as well as supply shocks, in the rise of global inflation. These influences come via commodity prices and monetary policy setting in particular. Demand effects look especially prominent for emerging economies although it is possible that the full effect of monetary expansion on inflation (and, by extension, interest rates) in the advanced economies has yet to be seen.
There has been a broad-based rise in inflation across economies in recent months. Headline inflation in the G7 has reached 3.5%, with inflation in the eurozone at over 4% - the highest in thirteen years. Outside Asia, inflation in emerging markets has doubled to 8% (see fig. 1).
The causes of this rise in inflation – and how long-lasting it may prove – are the matter of considerable debate. One of the main issues at stake is whether current inflation mainly reflects a series of supply shocks or rapid demand growth spurred by loose fiscal and monetary policy.
It is likely that both factors are in play, sometimes interacting as when the release of pent-up demand for certain goods and services meets supply constraints, causing inflation ‘hotspots’.
A useful starting point is the San Franciso Fed’s analysis that divides US inflation into Covid-sensitive and Covid-insensitive sectors and further divides Covid-sensitive sectors into portions sensitive to demand effects, supply effects, and those with ambiguous sensitivity. This analysis shows demand-sensitive items have been more prominent in driving the recent inflation rise than supply-sensitive ones (see fig. 2). But items with ambiguous sensitivity are also prominent, so the precise importance of demand-side factors is not completely clear.
A key factor driving headline inflation recently has been rising commodity prices. It is common to assume this is a supply-side issue, but it may well be linked to rapid monetary growth and so be a demand side issue. Importantly, this was also true in the 1970s when rapid money growth boosted non-oil commodity prices well before the main oil shock hit (see fig. 3).
The exceptionally rapid monetary growth seen in 2020 is an obvious candidate for the cause of the recent inflation rise, and the impact would normally be broader than just via commodities.
If we look at the cross-country statistical link between recent rises in inflation and money-supply growth in 2020, there is evidence of a link. For a sample of 53 advanced and emerging markets, broad money growth explains about a third of the cross-country variation in inflation increases since late last year. However, the link is much stronger for emerging markets, where money growth explains about half the cross-country variation in inflation increases. For advanced economies, the link is weaker and only just statistically significant (see fig. 4).
For emerging economies, we also find a strong statistical link between changes in exchange rates and inflation, reflecting widespread weakness of emerging currencies in 2020. This is also likely to be partly a side-effect of strong monetary growth as weak currencies will have fed into inflation expectations and encouraged the swapping of domestic for foreign currencies.
Another candidate for the cause of inflation increases is loose fiscal policy. The ‘fiscal impulse’ – the change in the structural budget deficit – was enormous in the G7 economies last year, peaking at 10% of GDP. This could now be feeding into faster price growth for goods and services. However, we do not find a strong statistical link between measures of the budget deficit and the rise in inflation in our sample of economies. At best there is a weak link for the advanced economies (see fig. 5).
The lack of a link to fiscal policy is surprising given that big deficits have been a big factor fueling monetary growth. It may reflect difficulties in measuring structural deficits during the pandemic. Lockdowns and various on- and off-budget government spending schemes have made measuring both the headline deficit and the output gap (a key input for the structural balance) difficult.
Lockdowns and various on- and off-budget government spending schemes have made measuring both the headline deficit and the output gap (a key input for the structural balance) difficult.
Overall, our analysis supports the idea that demand-side effects are an important factor behind the recent rise in inflation. But the evidence is stronger for emerging economies.
An optimistic interpretation of our findings is that the better inflation-fighting credibility of advanced economy central banks means that pass-through to inflation from temporary surges in monetary growth is low. The slump in velocity last year, manifested in the sharp rise in savings rates, also lessens the demand- and inflation-raising impact of high money growth. On this basis, central banks can be cautious about tightening policy.
More pessimistically, the generally long transmission lags in advanced economies (up to two years (see fig. 6). may mean the peak inflation effect is still ahead of us, with the big risks in 2022. Moreover, even if inflation so far in the advanced economies has a big supply-side element, a succession of large supply shocks in an environment of loose policy settings still has the capacity to push up inflation persistently via de-anchoring of expectations. On this basis, at least some pre-emptive action by central banks would be prudent.