What are the underlying causes of inflation?

Central bankers have been grappling with the increasing level of inflation in their economy but rates are starting to stabilise – CPI in New Zealand down from 6.9% to 6.7% and from 9.1% to 4% in the US. The US Fed Chair Jerome Powell has recently stated that it is not wage increases that were the reason for higher prices. There have been 3 upsurges in inflation of since the COVID-19 outbreak.

1. There was transitory inflation as the fiscal stimulus led to people wanting to spend more as supply chains were struggled to keep a pace with this demand for durable goods.

2. The war in Ukraine saw a spike in energy prices as economic growth recovered from the pandemic. This was independent of transitory inflation.

3. Profit-led inflation – this is when companies tell consumers a convincing story that allows them to increase their price with out reducing demand for the product and therefore making it more inelastic. Consumers believe the price increase is ‘fair’ or ‘justified’ and expectations are high. This has also been referred to as ‘sellers’ inflation, greedflation, excusflation. Isabella Weber, an economist at the University of Massachusetts at Amherst argues that a lot of the above factors have provided camouflage for firms to raise their prices – see link below from The New Yorker.

Euro inflation

In the Euro area the higher inflation so far mainly reflects higher profits and import prices since 2022. Profits accounted for 45%, import costs 40%, Labour costs 15% and Taxes having a small deflationary impact. However, workers will now be pushing companies for higher wages to maintain their purchasing power which could reduce profit margins to their lowest level since mid-1990’s if inflation is to return to its 2% target.

If profit is the prevalent issue concerning high inflation then other tools should be used like tax policies that target excess profits or incentivise investment in firms to increase aggregate supply (supply-side policies). The policy of interest rates should not be the only tool in the toolbox as there needs to be a better understanding of the causes of high prices the way government’s respond to future shocks.

Sources:

Europe’s Inflation Outlook Depends on How Corporate Profits Absorb Wage Gains. IMF Blog

The New Yorker. What if We’re Thinking About Inflation All Wrong? 6th June 2023

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