Macroeconomics

1 HOW RISING INFLATION AFFECTS THE ECONOMY

HOW RISING INFLATION AFFECTS THE ECONOMY

Student Paper

The question of whether high inflation will result from the economic turmoil

brought forth by the lingering pandemic and subsequent near-shutdown of commerce for

an extended period is becoming more concerning. Everywhere you look right now, prices

are rising: from groceries to housing to the price you pay at the pump, the cost of goods and

services have been rising at an alarming rate since the beginning of the year. This article

provides insight on how inflation impacts the global economy.

One needn’t be a soothsayer to tell that we are on the precipice of an inflationary period,

what with the headlines and latest economic statistics trumpeting that such an event is

imminent. Many economists are skeptical of President Biden’s 1.9 trillion dollar stimulus

plan, predicting that there will be serious repercussions. However, Janet Yellen, Secretary

of the Treasury, keeps trying to assure us that the United States is on watch and well

equipped to combat inflation. But we know this to be true; rising costs and higher rates do

not come without consequences.

President Biden’s plans and policies have been subjected to scrutiny from myriad

economists. They fear that the President’s stimulus initiatives may over stimulate an

economy already showing signs of recovery now that vaccines are ticking up and a return

to “normalcy” appears to just around the corner. Consumers, sick of a year of lockdown,

are raring to get out and consume; to dine out, shop, be entertained, and travel. Businesses

are reopening at near-to-full capacity and sporting events are allowing fans in the stands

2 HOW RISING INFLATION AFFECTS THE ECONOMY again. Restaurants are phasing out limited occupancy restrictions, and everywhere you

look you see what appears to be a pent up and voracious demand for these things.

Manufacturing, on the other hand, has been operating at reduced capacity and, as a

result, companies are experiencing supply bottlenecks and are unable to keep up with the

growing demand. Consequently, the price for goods and services is increasing. It is

Economics 101: Supply vs Demand.

The author chronicles this by providing incidences of inflation, stating that space on

container ships is up 180% over the year prior, and a semiconductor shortage triggered by

this year's surge in demand for tech equipment – brought on in part by the surge in

demand for computer and IT equipment necessitated by a large percentage of the

workforce being thrust into finding ways to do its job from home offices – is causing delays

in the production of vehicles, computers, and smartphones. He goes on to emphasize that

Brent Crude oil prices have risen above sixty dollars a barrel for the first time in over a year

after bottoming out below twenty dollars a barrel at this time last year.

When inflation rears its ugly head, interests rates rise. In 2011 the European Central

Bank erroneously raised rates in response to a temporary spike in inflation, with near

disastrous consequences. Greece and Italy’s economies crumbled, threatening to take the

global economy with it and they still haven’t recovered. In the article the author explains

why this is problematic, as temporary increases in prices embolden fiscal hawks who are

often complacent about the dangers of a weak economy.

In America, where increasing inflation expectations and a faster recovery mean price

increases are more likely to be persistent, higher inflation could trigger monetary policy

gyrations. The

3 HOW RISING INFLATION AFFECTS THE ECONOMY Federal Reserve has vowed to keep interest rates low and will continue purchasing bonds

in order to compensate for today's shortfalls. However, the current “average inflation

targeting” regime precludes a long-term or significant overshoot. To tamp inflation back

down, the central bank will eventually have to increase interest rates. The Author’s main

message, which seems self-evident, is that high inflation rates negatively impact the

economy and the markets. And while Biden’s ambitious stimulus packages are still needed,

especially when it comes to beginning the long overdue process of restoring the nation’s

crumbling infrastructure, he must persuade Congress, corporate America and the American

public to accept higher taxes to pay for it all – always a difficult and unpopular task – or

there will be very real and possibly severe consequences which could lead the nation back

into a recession.

From what I have learned from this article, and in this course, higher interest rates can

have far-reaching consequences, not only for financial markets here and globally, but for

each of us. We have become dependent on easy money, so much so that our economy and

almost everything in today's financial world is predicated on central banks maintaining low

interest rates for an extended period of time. The notion that the government can spend as

much as it wants, including President Biden’s proposed infrastructure bill, is based on this

notion; that cheap capital, which also informs today's steep stock market prices and

plentiful credit, will be around forever.

While free money, in the form of easy, near zero-percent credit and life-raft stimulus checks

for anyone who can fog a mirror is enticing, it is not sustainable. It seems to me at some

4 HOW RISING INFLATION AFFECTS THE ECONOMY point a reckoning awaits, and when it eventually comes, this economic house of cards –

built seemingly of smoke and mirrors and coupled with the lack of political will to enact

and adhere to sound fiscal policy – will come crashing down on all of us.

5 HOW RISING INFLATION AFFECTS THE ECONOMY

The Original Article

Inflate gate: How rising inflation could disrupt

the world’s economic policies

The debate is hotting up

Source: The economist.com,

https://www.economist.com/leaders/2021/02/10/how-rising-inflation-could-

disrupt-the-worlds-economic-policies

The debate about whether high inflation will emerge out of the pandemic is becoming more

pressing. In January underlying prices in the euro zone rose at their fastest pace for five

years. In America some economists fear that President Joe Biden’s planned $1.9trn

stimulus, which includes $1,400 cheques for most Americans, may overheat the economy

once vaccines allow service industries to reopen fully. Emerging bottlenecks threaten to

raise the price of goods. Space on container ships costs 180% more than a year ago and a

shortage of semiconductors caused by this year’s boom in demand for tech equipment is

disrupting the production of cars, computers and smartphones.

Headline statistics on price rises will soon contribute to the sense that an inflationary dawn

is breaking. They will go up automatically as the collapse in commodities prices early in the

pandemic falls out of comparisons with a year earlier, and the recent rise in the oil price

begins to bite—on February 8th Brent crude rose above $60 a barrel for the first time in

more than a year. In Germany the reversal of a temporary cut in vat has already helped

year-on-year inflation rise from -0.7% to 1.6% in a month.

6 HOW RISING INFLATION AFFECTS THE ECONOMY For most of the past decade the world economy’s problem, judged by central banks’ targets,

has been too little inflation, not too much. As a result it is easy to view the coming

acceleration in prices as welcome. In fact, it is worth worrying about, for several reasons.

One is that it weakens the hand of those arguing for more fiscal stimulus in places that need

it. There is little prospect of the euro zone sustaining higher inflation, for example. Its main

rate of interest has not been cut during the pandemic and its deficit spending remains

inadequate given its economic outlook and lack of monetary firepower. Much as the

European Central Bank mistakenly raised rates in response to a temporary burst of

inflation in 2011, the danger this time is that a temporary acceleration in prices emboldens

fiscal hawks who are complacent about the dangers of a depressed economy. The same

danger lurks in Japan, the archetypal low-inflation economy. Its prices started falling

during the pandemic. Japan will probably escape deflation this year, but beyond that it

looks destined to remain in a low-inflation trap, having seemingly given up on its brief

attempt to spring out of it in the mid-2010s.

Higher inflation could also cause gyrations in monetary policy in America, where rising

inflation expectations and a faster rebound mean price rises are more likely to prove

persistent. Financial markets imply a one-in-five chance that consumer prices will grow by

at least 3% per year on average over the next five years. The Federal Reserve has promised

to keep interest rates low and to keep buying bonds because it wants inflation to overshoot

its 2% target, in order to make up for today’s shortfalls. But its new “average inflation

targeting” regime does not allow for an enduring or large overshoot. Eventually the central

bank will want to raise interest rates to bring inflation back down.

7 HOW RISING INFLATION AFFECTS THE ECONOMY The faster prices rise this year, the sooner that tightening could come. Richard Clarida, the

Fed’s vice-chairman, has said that the central bank will make up only for inflation shortfalls

that have occurred over the preceding year, meaning the point at which catch-up is

complete could come surprisingly quickly. On February 7th Janet Yellen, the Treasury

secretary, tried to reassure critics of Mr Biden’s stimulus by saying that America has the

tools to deal with inflation. But higher rates are not without consequence, and if the Fed

finds itself pouring cold water on an overheating economy, the risks of another recession

will rise.

Higher rates also hold deep implications for markets. Almost everything about today’s

financial landscape is premised on central banks keeping interest rates low for a long time.

Cheap money lies behind the idea that the government can spend however much it likes—

including, say, on Mr Biden’s planned infrastructure bill—and underpins today’s sky-high

stockmarket values and abundant credit. An abrupt change in the interest-rate outlook

would be painful, as it was in 2013 when the Fed’s hawkish comments led to what became

known as the “taper tantrum”.

On Wall Street higher rates would be a shock. In emerging markets they would be

agonising. Many have been experimenting with unconventional monetary policy and bigger

budget deficits, following the rich world (see article). But their efforts assume that global

financial conditions will stay loose. Higher interest rates in America to see off inflation

would mean a stronger dollar and capital outflows from emerging economies, as in 2013.

This would imperil their finances and make it harder for them to fight the effects of the

pandemic. There is a lot to like about the idea of escaping the low-inflation, low-rate

8 HOW RISING INFLATION AFFECTS THE ECONOMY paradigm of the past decade. But higher inflation will expose the world economy and

financial markets to a bumpy ride.