Inflation has been rising for several months now. In the United States, the price increase rose to 6.2% in October, a level not seen for 31 years. In the Eurozone, inflation has risen to levels not seen since the euro creation. There is hot debate about inflation reasons, and opinions differ widely; Will there be a permanent period of rising prices, or are the fears of inflation exaggerated?

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On this page, you will discover the causes of rising inflation, the extent to which a return to normalcy is possible and the longer-term risks to prices.

Causes of the price increase

Inflation is an economic metric measured every month, while its annual variation is expressed as a percent. For example, an inflation rate of 5% means that consumer prices have risen 5% compared to the same month of the previous year. This definition is helpful to explain better the primary cause of the recent rise in inflation. After oil prices hit their lowest level a year ago, inflation has risen ‘mechanically’ since April 2021. In such a case, it is referred to as ‘positive base effects’ because last year’s prices used as a basis for comparison were low.

Besides shocks in commodity prices, inflation can also arise if there is an imbalance between supply and demand. If demand is too great compared to the economy’s production capacity, prices will rise. Conversely, when the amount of goods and services supplied exceeds the demand, a fall in price is usually the logical consequence.

US tax experiment

The past two years have been dominated by a tax experiment in the United States:

Total household income in the US has risen compared to pre-crisis income levels for the first time during an economic recession. Disposable household income usually declines with job losses because government support is insufficient to compensate for the fall in income.

Moreover, when the economic context is difficult, there is a tendency to hoard money as a precaution

Both of these factors lead to a contraction in demand, which in itself is deflationary. Unlike previous recessions, the US government has provided massive financial support to US families over the past two years. Three one-off payments were made, and higher unemployment benefits were foreseen. These fiscal measures have more than made up for the lower revenues caused by job losses in the US. Therefore, on balance, the combined disposable income of American households has increased.

Different situation today

The situation we find ourselves in today is different. After all, the price increase can be attributed to both high demand and supply problems.

The current crisis was initially deflationary because the corona measures limited the consumption of a whole range of services. However, demand for goods has been boosted during the lockdowns by the inability to consume certain services and by the higher disposable income of American households. The sudden increasing demand for goods put pressure on global production lines. What started as a shortage of semiconductors has now expanded to other components and semi-finished products.

In addition, the economy also had to deal with the supply issue . Due to the corona measures, many factories were forced to close their doors, especially in Asia, temporarily. Shipping costs also increased eightfold during the height of the crisis because the number of containers available was insufficient to ship goods. While worldwide there was a sharp increase in demand for all those goods. Combined with supply lagging due to various factors, high demand led to a supply-demand imbalance and inflationary pressures on goods. The sharp increase in prices for goods during the corona crisis was due to a supply-side that failed to meet the high demand for goods.

When containment measures were subsequently relaxed, demand for domestic services rebounded rapidly. This led to price increases for services such as tourism. In the jargon, this phenomenon is called “reopening inflation”.

Finally, higher energy prices have also contributed to inflation. The increase in energy prices can be attributed to several factors: strong demand following the lifting of containment measures, OPEC’s strategy to limit supply, the switch to renewables whose supply may be volatile, and also tensions between the European Union and Russia.

Towards the moderate inflation

The rise in inflation is thus largely due to the unique situation facing the global economy. However, initiating a spiral of inflation is only possible if the balance between supply and demand is changed sustainably. But there is hardly any evidence for such a scenario.

Two elements can slow inflation in 2022

First, the base of comparison will be higher in 2022 for several elements that make up the consumption basket, such as energy, used cars and car rental.

Second, the problems in global supply chains should disappear as consumption behaviour normalises to the benefit of services and the detriment of goods. In the meantime, the supply has also adapted to the increased demand, which has somewhat restored the balance between supply and demand. Both the production capacity of semiconductors and sea containers will increase in 2021. However, supply problems cannot be ruled out until the pandemic.

Driven by both elements, some disinflationary pressures are therefore likely.

And then there are the labour costs, which often represent the largest item of expenditure in a company. If productivity remains the same, an increase in labour costs causes an increase in unit production costs. In order to protect their profit margins, companies then try to pass on their increased production costs to consumers through higher selling prices. Today, wage inflation in the United States is more than twice that of the eurozone. Leading indicators point to further wage increases in the US. This wage inflation can be explained by tight labour market supply when labour demand is robust. Why are many people left out of the labour market? Because wage expectations have not been met, because they can afford not to work or because they want a better quality of life.

A correction mechanism could also restore the market equilibrium here. After all, higher wages could convince these people to return to the labour market.