Inflation rates are reaching record highs in most developed countries across the globe. In the US, inflation climbed above 6% in October for the first time since the 1980s. The same phenomenon is currently being witnessed in the UK, as inflation climbs above 4% – a first in 10 years. The recent spike in inflation is due to a combination of supply chain shocks and excessive demand, alongside large increases in the money supply. Whilst economists are uncertain as to whether inflation rates will continue to climb, it is almost certain that will persist for the next coming years, resulting in falling real wages and lower living standards for all.
Supply chains globally have been negatively impacted due to the coronavirus pandemic. The energy sector, in particular, has seen production fall to record lows; in 2020, annual oil production fell to 2010 levels. This has led to oil prices skyrocketing to $80, a 4x increase from its 2020 low of $20 per barrel. These higher oil prices have led to production costs rising for firms across all sectors, especially the meat and poultry industry. Since 2020, the price of ground beef has risen 30%, largely due to the higher production costs being passed onto consumers in the form of cost-push inflation. As a result, consumers are feeling the burden of higher prices, squeezing household budgets as inflation exceeds wage growth, resulting in falling living standards.
As pandemic restrictions gradually ease, aggregate demand has rapidly increased, putting upward pressure on prices. During the coronavirus pandemic, people were forced to remain in their homes; at the same time, shops were also put into lockdown, causing them to remain closed. This resulted in a sharp increase in household savings, with the household savings ratio reaching 30% in September 2020 – a record high since records began in 1963. As restrictions have been gradually eased, the savings ratio has fallen as consumers spend their pandemic savings. This has resulted in a sharp increase in aggregate demand, causing demand-pull inflation.
Money supply growth
Following the outbreak of the coronavirus pandemic, governments have run up large fiscal deficits to support the economy. In the US, the budget deficit reached over $3 trillion in 2020 – a 3x increase from the previous year, an outstanding 20% of GDP. This has caused government debt in the US to reach a record high – 110% of GDP, greater than that reached during WW2. A similar story has been seen in the UK, as the budget deficit exceeded 14% of GDP for the first time since the 1940s. Government debt also exceeded 100% of GDP in 2020, the result of running a £303 billion deficit in the fiscal year 2020/21. This excessive spending has resulted in a large increase in the amount of money in circulation in both the UK and the US. The result is too much money chasing too few goods, causing prices to rise.
Central Banks in both the UK and the US have also enacted expansionary monetary policy measures in the aftermath of the pandemic. In the UK, the bank rate was cut from 0.75% to 0.1% in March 2020. The Federal Reserve also introduced similar measures, reducing the discount rate from 3% in 2019 to 0.25% in 2020. This has made it cheaper for firms and individuals to borrow by reducing their debt repayments, thereby inducing demand-pull inflation. At the same time, quantitative easing has become more prevalent in light of the pandemic. Between March and June 2020, the Bank of England bought £100 billion worth of bonds. This is more than the amount spent on purchasing bonds between 2012 and 2016. The Federal Reserve in the US has engaged in similar measures; excess reserves have climbed from $1.5 trillion at the start of the pandemic to over $3 trillion by the end of 2020. Quantitative easing has the effect of lowering real interest rates, whilst increasing the amount of money circulating within an economy. The result has been higher inflation, hurting businesses and individuals as the real value of their money falls.
Ultimately, the current spike in inflation is the result of excessive demand, combined with supply chain bottlenecks and growth in the money supply. Whilst excessive demand is relatively easy for policymakers to handle, resolving the supply-side shocks without further increasing the money supply will prove difficult. As a result, it is unlikely that inflation rates will be falling anytime soon, with this having a devastating effect on firms and individuals alike.