As the vaccination drive gathers pace globally, infections and deaths have dropped substantially in several major economies. This is good news for policymakers who have been battling the pandemic for much of the past 18 months while also trying to keep their economies afloat. 

Although it appears that the world may have finally turned the corner on Covid-19, success in defeating the pandemic could give rise to another problem that had, until recently, been a distant threat. 

Thus far, price pressure in the western world has remained subdued – a holdover from the global financial crisis of 2008. Notwithstanding central banks’ ultra-loose monetary policy – rock-bottom or even negative interest rates combined with quantitative easing – and tight job markets, inflation has remained well below 2%. Some economists have gone as far as to declare that inflation is dead and issued warnings that developed nations, in particular the eurozone, could face “Japanification” – an unsavoury combination of low growth and low inflation. 

Initially, there were worries that the pandemic would have a contractionary effect. Now, rising inflation is becoming a concern. In the United States, the annual inflation rate reached 5% in May, the highest since August 2008. The trend in rising prices is also occurring on a month-on-month basis, which indicates that it is not a one-off phenomenon due to the “base effect” of suppressed demand and prices caused by last year’s lockdowns. 

The Federal Reserve’s preferred measure of inflation – the core personal consumption expenditure (PCE) index, which strips out volatile food and energy prices – rose 3.8% in the 12 months to May, the highest since June 1992. As price pressures continue to build, the Fed has recently raised its core inflation projection for this year to 3% from 2.2%, which it made in March, and now expects interest rates to be raised at least twice in 2023. Previously, most Fed officials had expected borrowing costs to remain near zero until 2024. 

As for the eurozone, inflation rose to 2% in May, the first time the rate has exceeded the European Central Bank’s target in more than two years. To some extent, this may be attributable to factory-gate prices in China, the world’s largest manufacturer. In May, the Mainland’s producer price index rose by 9% compared with last year, the fastest rate in almost 13 years. 

While companies may initially absorb these additional costs out of fear of losing price-sensitive consumers, this is not tenable in the face of a sustained increase in factory prices, and price rises will eventually be passed on to shoppers. 

There are a number of reasons behind this upward pressure on prices. Since the onset of the pandemic, major economies have flooded their markets with unprecedented amounts of money through a combination of easy fiscal and monetary policies. 

In the U.S., the Fed has injected massive amounts of liquidity into the financial markets to keep interest rates low. Consequently, the size of the Fed’s balance sheet has doubled to nearly US$8 trillion from US$4 trillion early last year, which in turn has allowed the White House to increase public expenditure by providing generous tax and jobless benefits. 

Flushed with cash and forced to stay at home, American consumers have also indulged in the purchase of goods – demand that has overwhelmed supply chains and pushed up prices.

Meanwhile, the pandemic’s lingering effects on global supply chains have continued to cause unwelcome disruptions. These supply bottlenecks have led to in shortages in products such as microchips and commodities. The cost of shipping has also been driven sharply higher, compounded by the grounding of Ever Given in the Suez Canal in March.

Add to the mix geopolitical tensions and national security concerns that have led governments to reshore production, multinational businesses are increasingly rethinking their existing supply chain models, which until now have been multijurisdictional, connected and just-in-time. 

Over the longer term, worldwide inflation appears inevitable as China faces the twin problems of an ageing population and dwindling labour pool. To counter that, the Central Government has recently announced that couples may have up to three children. Since its entry into the World Trade Organisation in 2001, China has been seen as a disinflationary force by “sharing” the country’s labour dividend with the rest of the world – in other words, China’s relatively cheap manufacturing has kept the global price of goods low. 

But a manpower shortage means the Mainland may no longer be able to provide the cheap manufacturing that has kept a lid on prices, even when factoring in the benefits of increased automation.

For now, the debate centres on whether inflation will be temporary, caused by the pandemic’s impact on both the demand and supply sides. If so, it could dissipate, given the significant slack in the labour market. On the other hand, the current upsurge in prices could fundamentally change inflation expectations, and take the form of a vicious spiral of higher prices and higher wages resembling conditions in the 1970s. 

The former narrative appears to be the dominant view for now. In fact, the viability of the massive borrowing and spending programmes by governments are dependent almost entirely on expectations of a drawn-out period of low interest rates and inflation.

Should the situation change drastically, governments, corporations and households – which have been incentivised to take on vast amounts of debt – would be exposed to the risk of rising interest rates. So it is crucial to start a serious discussion to consider this possibility.

 It will be difficult to predict the path of inflation until the data “noise” associated with the pandemic can be filtered out, which will take some time. But on balance, the risk of inflation appears to be tilting towards the upside. 

Given that there is a lag between policy changes and outcomes, an incomplete or incorrect assessment engendered by hawkish attitudes could have the unintended effect of prematurely slamming the brakes on fiscal and monetary stimulus, which would in turn scupper recovery efforts in fragile economies. There is also the risk that markets could suffer major and drastic withdrawal effects as dovish attitudes and reflationary policies come to an abrupt halt. World leaders will have to walk a fine line between fighting the pandemic and inflation.

Wilson Chong, [email protected]