The Micro and Macro Costs of Inflation: 2022 Edition
The volatility, reduction in real wage and lower living standards caused by inflation are often noted as core costs. These effects are aggravated by the methods used to combat the phenomenon, for monetary policy tightening conventionally causes decreased demand, a reduction in investment, and as a result, lower GDP. However, while the US has been in a technical recession for over a month now, and the UK is likely to join, labour market tightness in both economies illustrates that central banks’ actions to combat current inflation has yet to make households feel recessionary pressure. However, this mis-match between supply and demand for labour makes a wage-price spiral more likely, risking inflation becoming permanent and expectations de-anchoring into the future. While data illustrates this de-anchoring has occurred at a low level, a recent quote from a Sky News interview that “there’s no light at the end of the tunnel, it’s just going up” encompasses households’ price expectations. This, alongside recent IMF reports that next year will feel more like a recession, suggests even in this current crisis, the pain will not be avoided, merely delayed. This is hugely negative for many households who, for most of 2022, have already been struggling.
Households have been changing their consumer habits, from cooking at home instead of eating out, to cooking in air fryers/slow cookers rather than in ovens. Additionally, food choices have shifted, as illustrated by the decline in Beyond Meat’s share price by nearly 68% since early August, as ‘flexitarian’ households return to the cheaper option of eating meat. The inflationary impact on other micro-habits is not so clear, with the Fed finding the work from home (WFH) trend contributed to the current inflation, and others arguing the trend could ease inflationary pressures on households thanks to childcare and transport savings. However, a large contributing factor to current inflation is the energy crisis, hence there is an argument that the WFH trend may turn-around, as people begin going to the office to save money on electricity and heating. While these changed habits illustrate inflation’s pervasiveness, with all households affected, they represent a microcosm for more serious micro-impacts. In June, Asda’s Income Tracker revealed 20% of households in the UK had negative discretionary income, hence their income no longer covered essential spending. Since UK inflation has risen further, hitting 10.1% in September, this figure could only have increased.
From a socio-economic standpoint, this heat-versus-eat dilemma faced by households is arguably the most damaging micro cost of inflation. Furthermore, while wages could rise eventually in-line with inflation, pensions and savings cannot. This suggests pensioners and the elderly are disproportionately hurt by inflation, something that is likely to be seen over the coming months. Thus, the socio-economic effect, particularly on society’s most vulnerable individuals, is large. Furthermore, increased financial stress risks impacting mental health, while the lack of ability to heat homes, and potential for blackouts across Ireland and the UK, means physical health is also likely to falter. Given that the NHS is prepared to be under increased pressure all winter, and the HSE is increasing recruitment, this micro cost of inflation is clear.
The pervasiveness of inflation impacts all generations, including future ones. As households prioritise where to spend their reduced real income, moral and ethical spending considerations are likely to be replaced by the requirement to survive. A recent survey illustrated that 59% of CEOs believe ESG considerations will take a backseat due to inflation and impending recession, encompassing the impact on firms too. Furthermore, with a core cause of 2022’s inflation being rooted in energy, other less environmentally-friendly energy sources are being sought. Indeed, the EU has been increasing coal production amidst a global rush for the commodity, alongside other more heavily polluting fuels. This shows that as we prioritise the present, future generations are likely to experience an indirect knock-on effect of these inflationary pressures.
It is worth taking a deeper dive into the costs for firms, who usually benefit from a low, steady inflation rate. However, the aforementioned labour market tightness, coupled with the rising costs of keeping stores, industrial units and restaurants/pubs open due to high energy bills, illustrates that the root causes of this high, volatile inflation, alongside the uncertainty that accompanies the phenomenon, negatively impacts businesses. Small-medium enterprises (SMEs) who may struggle to cushion cost increases, alongside businesses with lower margins, are likely to be particularly hurt. Therefore, business owners must be flexible in evaluating their entire value chains, while heightening employee productivity and considering new approaches to everyday tasks. While this shake-up could be positive for business-owners in the long run, and some argue that creative destruction leaves immediate pain, but long-term gain, there are questions over the extent to which business-owners can ride-through this current period through merely adapting, or whether more government support is needed, particularly for SMEs, to survive.
This shake-up extends globally, and here-in lies the macro costs of inflation. While many micro costs stem from inflation itself, the macro-impacts are also rooted in the response to the phenomenon – namely in the effects on output of monetary policy tightening. This trade-off between inflation-targeting and a reduction in economic growth can lead to a difficult dilemma, seen recently in the UK, between fiscal and monetary policy. Where monetary policy should be independent from politics, political myopia and a requirement to heed manifesto pledges means that the two can, in periods of (particularly supply-side) inflation, work against one-another. The macro-effects of this trade-off regarding financial stability and further recessionary fears are clear, with Moody’s recent de-rating of the UK’s financial outlook to ‘negative’ and the volatility of the pound encompassing this. However, whether this is causal, or rather, driven by the political instability of a nation that will have three prime ministers within two months, illustrates the political effect of inflation. While political myopia, and a need to impress the electorate often drive political behaviour, lessons from the 1970s of valuing central bank independence, and using fiscal policy to support both monetary policy, and those who will be hurt by the tightening is crucial.
Despite the macro-environment differing slightly from the 1970s, the root causes of this inflation, namely loose monetary policy (quantitative easing) during Covid-19, alongside the supply-side shocks in energy, is similar, suggesting policy lessons can be sought from this parallel. Volcker’s famous re-anchoring of inflation expectations, gained through strong communication, transparency, and hard-line monetary policy tightening, encompasses this. Where the US struggled in the 1970s, other economies, namely Germany, performed better. This is likely due to Germany’s focus on monetary targeting, alongside German fears post hyper-inflation, ensuring that a low, stable inflationary environment, alongside well-anchored inflation expectations, were not taken for granted. The stability of inflation expectations has been well documented over the last decade and during the Great Moderation, meaning policy-makers’ stances towards these expectations may have relaxed. Hence, when various data-points, including US TIPs vs 5 year Treasury bonds (began deviating in Feb. 2020), Bank of England inflation attitudes survey (by June 2021), and the ECB’s Professional Forecasters’ Survey (by Q1 2021), began to suggest inflation expectations were de-anchoring, multiple Central Bankers continued to argue that inflation was transitory. Therefore, monetary policy may have to shift to re-anchor these expectations, with potential concerns for the impact on future monetary policy. Is the success of inflation-targeting compromised when fiscal and financial conditions are weak? Will trust in Central Banks decline in the long-term, suggesting a need for changed policies/targets? Will the independence of Central Banks be threatened? These, alongside many more questions, arise from inflation, suggesting shake-up is not only required on a micro- level, but also on a macro, institutional level.
Furthermore, this extends to global institutions. Lael Brainard recently called for a more global approach to central banking, while noting the Fed’s attentiveness to Emerging Markets’ (EMEs) financial vulnerabilities. Up to October 2022, investors withdrew a record $70 billion from EME bond funds. These investments are crucial for EMEs’ economic development, and symbolise the impact of inflation in a globalised world. This is something not experienced before, with the Governor of the Central Bank of India recently noting “the world is in the eye of a new storm.” Therefore, these spillover effects of inflation in a globalised world illustrate a macro cost of the phenomenon on global economic development.
Thus, this encompasses the pervasiveness of inflation. From changing households’ habits, to the requirement for firms’ flexibility, alongside a need to evaluate fiscal and monetary policy on a local and global scale, it is evident that high, volatile inflation can be destructive. Ultimately, while lessons from the 1970s could be utilised by policy-makers, increased globalisation, the tightness of an un-unionised labour market, and the dollar’s strength, means this is a different and difficult inflationary situation. Therefore, uncertainty becomes a barrier to the successful and swift mitigation of inflation, as well as driving the micro and macro costs of the phenomenon.