Grace Gollogley, BSc in Global Business student at Trinity Business School, plots the course of inflation in the wake of recent price hikes and contends that governments’ monetary and fiscal policies must be properly evaluated and modelled before implementation – if not, inflation will hit us at a still higher price.

Tomato shortage – a symptom of inflation? by Grace Gollogley.

It’s not immediately apparent that the recent shortages of tomatoes and other fresh produce in Europe are symptomatic of economic distress. A poor growing season, changes in weather patterns due to climate change or even the regulatory difficulties posed by Brexit in the case of the UK might seem more likely. These are indeed the main causes, though there is another factor to be considered. The prohibitive cost of electricity this winter of 2022-23 has meant that farmers have cut back on their use of greenhouses, ultimately causing major UK retailers to set limits of three punnets of tomatoes per consumer [1].

Natural gas, used to heat Irish greenhouses until early summer, is costing four times the long-term average [2]. This is just one commodity which has dramatically increased in price over the last two years, and is indicative of the turbulent state of the global economy. In fact, inflation can be said to be an additional feature of the condition of ‘permacrisis’ which characterises the modern era. We live in interesting times, which pose interesting questions. Is this period of inflation caused by the extraordinary events of our time, or is it a question of mismanaged monetary policy? Who is most affected and why? And what should be done about it?

Price instability is an economic constant  

The rate of increase in prices over a given period of time is not a new phenomenon, but one that is inevitable for any economy. When it comes to inflation, moderation is key. It’s widely accepted that maintaining inflation at a low and predictable rate is optimal economic policy.

A slow but steady increase in prices encourages consumers not to delay purchase-making, thus facilitating stable economic growth. Inflation that is too high and unpredictable causes a massive reduction in consumer purchasing power and necessitates painful austerity measures in order to be resolved. On the other extreme, deflation discourages current consumption and results in negative economic growth.

Hence, inflation is not something we should try to eliminate, but rather an economic variable that should be managed and controlled. Over the last decade, inflation has averaged 1.88% in the US [3] and the EU has had a 20-year average of 2.31% [4]. Against these, the annual inflation rates of the US of 8% in 2022 (preceded by a 40-year high of 7% in 2021 [5]) and of 10.4% in the EU in December 2022 [6] are evidently out of the ordinary.

The effects of these dramatic price increases are only too visible in everyday life. For the last two years, consumers worldwide have struggled to make ends meet, and the phrase ‘cost of living crisis’ has loomed ever larger in the headlines. To understand why and how inflation has become one of our most pressing issues today, we must go back to 2020.

Inflation increase: It all began with Covid

The effect of the Covid-19 pandemic was initially negative with regards to inflation, as economic activity ground to a halt due to health restrictions [7]. This state of affairs did not last for long. In a speech made by Philip Lane, the Governor of the European Central Bank (ECB) at Trinity College Dublin in March 2023, he noted that inflation had risen very quickly from the middle of 2021 [8].

The Central Bank of Ireland (CBI) attributed the surge in inflation in 2021 to three causes: a rise in global energy prices, price rebounds for some goods which had become cheaper during the pandemic, and a combination of renewed demand and supply chain bottlenecks which were a relic of health restrictions [9]. Low interest rates spurred a demand for housing which added to inflationary pressures [10]. Most people expected that post-pandemic inflation would prove to be temporary.  Economists in 2021 predicted that the key drivers of inflation would recede in 2022.

While the possibility of wages being set in anticipation of price increases was explored, it was the opinion of Gabriel Makhlouf, governor of the CBI, that the presence of wage-bargaining institutions and an inflation-targeting ECB would prevent this from happening [11]. He also cautioned that the higher price rates of 2021 should be viewed in the context of a period of inflation that was below the ECB’s target of 2% annually.

However, the invasion by Russia of Ukraine was to overturn forecasts of a return to economic stability. The European economy in particular was greatly affected by the conflict, especially with regard to energy and food markets [12]. The Eurozone was dependent on energy imports for more than half of its needs in 2020, with Russia being a key supplier.

Russian and Ukrainian imports of food such as wheat, oilseeds and fertiliser dropped off with the onset of the war, pushing up prices and adding to the lingering pandemic inflationary pressures. The energy-intensive nature of food production didn’t help matters either.

The result in economic terms was an increase in food prices for EU consumers of 14.1% in January 2023 compared to the year before, and edible oils were nearly 50% more expensive than at the start of 2022. The economic effects did not only affect the EU-the rise in global commodities prices aggravated existing inflation in markets such as the US [13].

Always and everywhere a monetary phenomenon?

All that’s been discussed so far would seem to suggest that the high inflation we are experiencing at present is a result of pandemic and war. However, this flies in the face of monetarism, and Milton Friedman’s oft-quoted phrase that ‘Inflation is always and everywhere a monetary phenomenon’. In economics, the quantity equation states that if the velocity of money in circulation is constant, prices will rise if the money supply increases faster than the quantity of goods and services produced.

Empirically, an increase in the money supply occurs in tandem with an increase in inflation. Monetarism holds that governments and central banks are responsible for inflation, as they control the money supply in the economy [14].

What reasons then do governments have to increase the money supply and cause inflation? Firstly, it’s a means of financing public expenditure. Printing more money drives up wages and pushes people into higher income brackets, meaning that they’ll be taxed at higher rates. It’s for this reason that inflation is sometimes called taxation without representation.

Another motive for increasing the money supply is to promote full employment. Spending money stimulates the economy which in turn stimulates employment but also inflation, as per the Phillips curve. A final reason posits that inflation occurs as a result of the mistaken policies of central banks seeking to avoid deflation [15].

Over the last 20 years, the money supply in the euro area has increased more quickly than the supply of goods and services, creating major inflation potential. The ECB’s quantitative easing programme which saw the mass purchase of government bonds (rolled out to combat the sovereign debt crisis) only served to exacerbate this, increasing member states’ spending power and compelling providers of public goods to drive up prices. The sudden restriction on supply caused by pandemic regulations meant that inflation finally became very apparent.

It takes two

While the pandemic was the catalyst in this particular inflation equation, we can now see that monetary policy in the decades prior to the event was the primary element. The measures taken during the pandemic by governments to lessen immediate economic hardship also aggravated the situation. Unemployment payments and stimulus packages increased the money supply still further at a time when demand was drastically reduced. Consumers saved, and the release of pent-up demand when lockdowns ended resulted in price increases.

The rise in commodity prices attributed to the Ukrainian War can also be linked to monetary policy decisions. Energy prices were rising even before the war, as central banks pursued policies that stimulated economic demand and hence demand for raw materials. As commodities are primarily traded in dollars, if ECB monetary policy causes the depreciation of the euro, prices will rise in the Eurozone.

Furthermore, those countries that export commodities hold large euro and dollar reserves and seek to protect themselves against EU and US inflation through price increases. Therefore, there are monetary and economic variables aside from the current conflict that contribute to inflation [16].  

Who wins and who loses?

As already discussed, inflation benefits governments as it reduces the real value of public expenditure and debt. People who hold physical assets will see an increase in the value of their investment. Savers, workers and retirees on fixed incomes, borrowers on variable rates and the wider economy suffer from inflation [17]. Additionally, when certain price changes affect more people than others, particular cohorts in society will be more impacted.

With regards to current inflation of energy prices, lower-income households, the elderly and rural households lose out as they spend a greater proportion of their income on this commodity than other groups [18]. In Ireland in 2022, it was estimated that inflation rates are 0.8-1.5% higher at the bottom of the income distribution than at the top [19]. Anti-inflation measures therefore must be targeted at those most in need of help.

Inflation: Finding a cure

The Economic and Social Research Institute’s (ESRI) Spring 2023 bulletin forecasts that inflation will slow alongside falling energy costs, however price levels will remain high and there is a risk that core inflationary pressures will be replaced by wage-based price increases [20]. In February 2023, the Irish government introduced a package of cost-of-living measures designed to help those most affected by inflation.

These included business supports, extensions to cuts on VAT and customs duties, supports for families with children of school-going age and payments to social welfare recipients. While the ESRI found that lower-income households would benefit more from the package than more affluent households, its cost is relatively evenly spread across the income distribution so both cohorts gain the same in cash terms. The institution cautioned therefore that further packages and budgets should be designed so as to avoid stimulating demand-side inflation.

At the EU level, the ECB decided in December 2022 to raise key interest rates by 0.5%, as a precursor to further increases. Interest rate hikes reduce demand and prevent an upward shift in inflation expectations. From March 2023, the ECB will also roll back its asset purchase programme, causing a decline in the money supply [21]. Across the Atlantic, President Biden’s Inflation Reduction Act was signed into law in August 2022.

Despite the name, analyses of the legislation suggest that it will have little to no impact on inflation in the near future. While the bill will reduce the price of energy, prescription drugs, and health insurance premiums, and reduce the US’ budget deficit, the effect of the changes on the economy over the next decade is forecast to be negligeable. Some economists even warn that the new health care subsidies may even be inflationary [22].

When it comes to tackling inflation, governments and central banks must tread a fine line. If the ECB raises interest rates too much, it risks arresting economic growth [23]. If the fiscal policies employed by the US and Irish governments aren’t carefully targeted, there’s a chance that they might add to inflation rather than alleviate it. Monetary and fiscal policies therefore must be properly evaluated and modelled before implementation.

According to Milton Friedman, the cure for inflation is straightforward-governments must stop printing money. To do so is to risk a temporary slowdown in economic growth, and the possibility that the measures employed may do more harm than good. However, as long as economic growth is stable, unemployment is low and interest rate hikes are kept below the rate of inflation, policymakers should persist in efforts to bring inflation to an acceptable level.

Useful links:

• Link up with Grace Gollogley on LinkedIn
• Read a related article: Greenflation: The dirty cost of building a clean and green economy
• Discover Trinity Business School, Trinity College Dublin
• Apply to study at Trinity Business School.

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