The rich world is witnessing inflation of the kind that it hasn’t seen in decades.
Inflation is the rate of price rise. In February, according to the latest data available, the retail inflation in the United States stood at 7.9 per cent. The last time it was anywhere near this level was in January 1982 — when it was at 8.4 per cent. Further, in January, the retail inflation in the United Kingdom was at 5.5 per cent, the highest since March 1992 — when it was at 7.1 per cent.
When it comes to the Euro Area, countries that use the euro as their currency, inflation in February stood at 5.9 per cent. This is the highest it has ever been since inflation in the Euro Area was first measured in January 1997. What this means is that inflation in the US, the UK, and the Euro Area is at a four-decade high, three-decade high, and a two-and-a-half-decade high respectively.
In Japan, the retail inflation in February stood at 0.9 per cent. In comparison to other rich countries, this is very low, but the last time inflation was anywhere near this level in Japan was in April 2019, when it was at 0.91 per cent. It is important to understand that for many years Japan has been struggling with very low inflation and even falling prices. Analysts now believe that inflation in Japan may touch 2 per cent this year.
The American treasury secretary Janet Yellen summarised the situation well when she told CNBC: “We’re likely to see another year in which 12-month inflation numbers remain very uncomfortably high.”
When Covid started to spread at the beginning of 2020, economic activity collapsed all across the world. The consumer demand for goods and services fell as well. When consumer demand fell, businesses had to cut prices in order to encourage people to continue buying stuff. This led to inflation collapsing through much of the rich world. In the US, the retail inflation in April 2020 stood at a very low 0.3 per cent. The Euro Area saw a deflationary scenario between August and December 2020. Japan saw deflation much longer: from September 2020 to August 2021. A scenario of falling prices is referred to as deflation. In the UK, inflation touched a low of 0.2 per cent in August 2020.
Economists fear deflation as much as they fear inflation, if not more. When people see prices falling, an expectation of prices falling further tends to set in. In this scenario, they postpone their purchases, in the hope of getting a better deal. When this happens, businesses suffer and so does the economy.
In order to ensure that deflation or a period of low inflation doesn’t set in for the long-term, central banks of the rich world printed a lot of money. An estimate made by The Economist suggests that money worth $12 trillion was printed in total.
The idea was to flood money into the financial system, drive down interest rates, encourage people to borrow and spend, and companies to borrow and expand. This would help getting economic growth going again. Governments also handed over this money directly to people by depositing it in their accounts and by issuing cheques and pre-loaded debit cards. This put purchasing power directly in the hands of people.
People had money to spend. At the same time, due to the spread of the pandemic, business supply chains which move finished goods and intermediary goods all across the world, broke down. This created a shortage of goods. We had a situation where people had money and were willing to spend it. This at a time when the supply of goods was down. Hence, by mid- to late-2021, low inflation gave way and prices started going up.
Central banks around the world have been caught napping on this front. As Mervyn King, former governor of the Bank of England, put it, “A satisfactory theory of inflation cannot take the form ‘inflation will remain low because we say it will’.” Central bankers kept telling the world that inflation was transitory, until it wasn’t. And then, on February 24, Russia attacked Ukraine…
This pushed up prices further given that both Russia and Ukraine are very important commodity exporters. Russia is the world’s second-largest exporter of oil and the largest exporter of natural gas. Along with this, Russia is also the world’s largest exporter of wheat. Ukraine is the fifth largest. The supply of these commodities has been disrupted due to several reasons, including sanctions, export bans, difficulty of movement and lack of availability of insurance and trade finance.
Hence, the current bout of multi-decade high inflation in the rich world is essentially due to three reasons: money printing carried out by central banks to lessen the negative economic impact of the pandemic; the disruption of global supply chains; and Russia’s attack on Ukraine. Any inflation due to the shortage of food grains, oil and gas and other commodities is likely to spread through other parts of the world. In fact, that is already happening.
As Mohamed El-Erian, the chief economic adviser of Allianz, told CBS: “We will probably get very close or above 10 per cent [inflation] before we come down.” This, he felt, would be “because of the disruption that Putin’s war implies for commodity prices, supply chains, and shipments”.
The one clear impact of Russia’s attack on Ukraine has been the jump in the price of oil. The price of one barrel of Brent crude oil was around $80 at the end of 2021. In March, the price had crossed $120 per barrel. It is currently back to around $100 per barrel as there are fears of Covid spreading across China — leading to a fall in global demand for oil.
The reason for the rise in oil price is very straightforward. Russia is the second-largest exporter of oil in the world. Data from the Observatory of Economic Complexity (OEC) suggests that, in 2019, Russia’s share of overall global exports of crude oil stood at 12.5 per cent. The future supply of this oil is now in jeopardy due to a number of reasons highlighted earlier.
Most countries in the world import oil. Hence, higher oil prices mean that these countries will have to increase the price of products like petrol (gasoline) and diesel. The higher fuel prices across the world will increase the cost of movement of human beings and the cost of transportation of goods, and thus lead to higher inflation.
Inflation impacts private consumption negatively. This impacts businesses and, in turn, slows down economic growth.
Other than being the second-largest exporter of crude oil, Russia is also the largest exporter of natural gas. Natural gas is used for heating purposes across Europe. It is used for cooking purposes as well. It is also used for making fertiliser, where natural gas is the source of hydrogen. Hence, if natural gas becomes expensive, fertiliser prices also go up; they have been touching all-time high levels, and this will ultimately feed into higher food prices all over the world.
If a government subsidises fertiliser for farmers, then it will have to pick up the tab for the same and, in the process, borrow more.
Russia is the largest exporter of wheat in the world. Ukraine comes fifth. Together, the countries are responsible for around a fourth of the global exports of the food grain. A recent news report in the Wall Street Journal pointed out: “Some 50 countries, mostly poorer nations, import 30 per cent or more of their wheat supply from Russia and Ukraine.”
This supply is now disrupted and has pushed up the price of wheat. The Middle East countries import around a fourth of the total global wheat imports. Egypt is by far the biggest importer of the food grain, having imported more than a tenth of the global imports in 2019. Turkey imported close to 5 per cent. Food prices in both these countries will come under pressure, especially in Turkey where retail inflation was already higher than 50 per cent in February. Egypt has long had a government programme of subsidised bread. An Egyptian delegation is visiting India in order to explore possibilities of importing wheat from India given that supply from Russia and Ukraine are broken.
Russia is also the world’s largest top exporter of raw nickel. Nickel prices, despite having fallen over the last month, are still way above where they were at the beginning of the war. Nickel is a very important ingredient that goes into the making of lithium-ion car batteries. As Vaclav Smil writes in How the World Really Works, “A typical lithium car battery weighing about 450 kilograms contains about… 27 kilograms of nickel.” This will push up the price of electric vehicles and slowdown the move towards electric vehicles.
Other than nickel, Russia is a top exporter of coal. In 2019, it was the third-largest exporter of coal globally. A bulk of the electricity across the world is still generated by burning coal. Hence, higher price of coal also means higher cost of electricity generation. Electricity prices going up will push up the cost of production of goods.
Of course, this also depends on whether governments across the world pass on the cost of higher electricity to end consumers.
That aside, coal is an important element in the making of steel — and steel is important in the making of everything from real estate to cars. This is one way how inflation will pass through the economic system. Car makers have already started raising prices.
The financial cost of the war will not just be borne by Russia and Ukraine; it is already being borne by countries all across the world in the form of higher inflation. Russia is a major commodity supplier to the world. While it is the largest country in the world in terms of area, it is ninth-largest when it comes to population: so, it still has a lot of commodities left over after its internal use.
Given this, if the war continues, the world will continue to pay for it in the form of higher inflation. If governments protect citizens by subsidising price rises, then they will have to end up borrowing more money or cut expenditure somewhere else and that will have its own set of repercussions.
Central banks have stopped printing money and at the same time decided to start raising interest rates. Earlier this month, the Federal Reserve of the United States raised its key short-term interest rate by 25 basis points. One basis point is one hundredth of a percentage.
Jerome Powell, the Chairman of the Fed, in a speech on 21 March said: “There is an obvious need to move expeditiously to return the stance of monetary policy to a more neutral level.” Many a time, central bankers do not speak in simple English. Powell basically meant that in the time to come, the Fed could raise interest rates at the rate of 50 basis points per meeting to control inflation.
Other than this, the Fed is also expected to start gradually removing all the money it had printed and pumped into the financial system. The Fed plans to suck out up to $95 billion per month.
The expectation of these moves has started moving interest rates up. At higher interest rates, people are expected to borrow and spend less. This will bring down consumer demand and in the process cool down inflation.
The US Fed expects the inflation to come down dramatically to 2.6 per cent by the end of this year.
The other rich world central banks are expected to work along similar lines. The hope is that these measures will help in controlling inflation.
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