Inflation in the US and the UK has reached its highest rate in decades, matching price rises across much of the developed world over the past year. Startling increases in specific goods and services, such as gas in the UK, were earlier attributed to the aftershocks of Covid’s first year as economies reopened. But with inflation now remaining stubbornly high, claims that rising prices are only a transitional problem are clearly wrong. We are, instead, entering the early years of a new, high-inflation, supply-constrained world that conventional economics and economic policy will find hard to manage.
Two conventional explanations can be dismissed. The growth in the money supply has been explosive over the past decade, as the major central banks turned to quantitative easing (QE) to support their economies after the financial crisis. QE involves the central bank issuing huge new quantities of electronic money, which it then uses to buy assets – typically government bonds. The Bank of England has now issued £895bn of new money through QE since 2009.
Crude economic theory suggests that issuing money like this should lead to disastrous inflation, as more money in circulation chases the same supply of goods and services, bidding prices upwards. But although some specific asset prices, such as US shares, have risen, prices in general over the past decade have at various points risen sharply, been fairly steady, or even fallen. There is no obvious, stable relationship between inflation and growth in the money supply.
The belief that inflation is due to rising wages is not empirically supported either. The theory here claims that rising prices will cause workers to demand pay rises, increasing costs to suppliers and so forcing them to raise prices even higher in the dreaded “wage-price spiral”. But it is glaringly obvious that price inflation today has little or nothing to do with wage rises. Prices rose across many different sectors of the economy last year, but in the US and the UK, there was no clear relationship between price rises and wage increases in a given sector. In the US, some parts of the economy, such as motor vehicle manufacturing, had big consumer price increases but very little change in wages. Others, such as nursing, even had wages rise and prices fall.
Instead, the inflation we are seeing today is emerging as a result of ecological decay. Almost every week brings news of fresh environmental calamity, from bushfires to record temperatures. These have a direct impact on supply, from coffee (hit by exceptional droughts in Brazil) to semiconductor chips (hit by droughts in Taiwan and wildfires in Texas). The insurer SwissRe has estimated the global cost of extreme weather in the past year to be $250bn – up 24 per cent on 2020, itself well above the ten-year average cost. Our environmental forecasting models indicate that these ecological shocks will only worsen over time.
Usually, we would think that one-off supply shocks have only limited impact on broader inflation. If there’s a shortage in some good or service, this may be something of a temporary nuisance, but it’s generally possible to buy something different, and for investment to increase supply of the affected product over time. The supply shock hits the market, pushing up prices, and then gradually fades away, leaving little impact on inflation.
There are a few commodities that are so ubiquitous that a price rise might induce more general inflation. Oil is the most obvious example, with changes in its price having an impact across the entire economy, and so rapidly changing the rate of inflation. In general, however, no good or service is so important that it dominates everything. But if those supply shocks keep happening across different markets – whether due to floods or fires or disease outbreaks – the cumulative impact will be to force prices up, and then keep them there.
Our existing set of policy tools for inflation will become increasingly redundant. The classic monetary policy response is to push up interest rates to make borrowing more expensive and so reduce demand. This is, at best, useless. As the Bank of England governor, Andrew Bailey, has pointed out, “monetary policy will not increase the supply of semiconductor chips, it will not increase the amount of wind… and nor will it produce more HGV drivers.” Pushing up interest rates will make investment more expensive, reducing the likely future supply of goods and services: if we invest less today, we can generally expect less output in the future.
Worse yet, increasing the interest rate in mistaken response to complex environmental shocks and shortages simply reinforces the demand impact of those shocks without necessarily changing their price effects. As demand for goods and services falls, demand for labour from employers could also fall. “Stagflation” – rising unemployment as well as rising inflation – would be the result. Monetary policy should, instead, accommodate for shocks by keeping interest rates low and credit easily available.
But conventional fiscal policy won’t work, either. Cutting government spending in the face of repeated supply shocks will be similar to raising interest rates: squeezing employment without doing much for prices. The push by the US treasury secretary, Janet Yellen, to promote “modern supply-side economics” – directing investment into shortage industries, such as energy and semiconductors – makes far more sense. But its impact will only be felt in the future.
The ideal policy in response to repeated environmental shocks is one that conventional economics has tended to scoff at, but which is emerging as common sense: price controls. A recent paper in Econometrica shows that a market with a price control may offer a more efficient means to allocate goods and services when inequality is high than a free market alongside government transfers. This is because, at high levels of inequality, taxing the very wealthy is easier said than done. The authors demonstrate that under these circumstances, fixing or regulating the price can be a preferable solution.
Price caps in the UK’s domestic gas markets fit this situation, and the authors themselves note that rent caps and minimum wages can function in a similar way. All three regulate the price of a specific good or service in conditions where inequality is high, effecting a redistribution through the regulated price to lower-income consumers, and so achieving a more efficient allocation of resources than a pure price mechanism. This isn’t an argument for general price controls, but regulation of certain goods or services in response to specific shocks can make sense. The Treasury is reportedly considering a mechanism for the gas market that would work along these lines.
We live in highly unequal economies battered by environmental calamities. If the goal is to provide security against such shocks, and to do so fairly for all, specific, targeted controls are the right approach.
[See also: Why inflation could break Britain]