Could the COVID-19 pandemic cause prices to rise?

Information verified correct on January 28th, 2021

For years central banks like Federal Reserve thought they understood why inflation fluctuated and how to keep it steady. Central banks felt that as long as they could keep inflation on an even keel, it’s probably a sign that they were also keeping the economy on an even keel. But for the past decade, inflation hasn’t played by the rules.

Despite high employment before the pandemic in places like the USA, which normally causes inflation to rise, it’s been mysteriously low across much of the rich world, and central banks seem unable to revive it. Low inflation means that central banks are less powerful than we thought or less powerful than we hoped.

This is particularly worrying as the world faces a period of profound economic uncertainty making it more important than ever to solve the great inflation mystery and repair the global economy. Inflation is when prices rise across the economy, it helps explain why a big mac cost less than $3 20 years ago but is nearest $6 today.

The traditional explanation is too much money chasing too few goods. According to this logic, if a central bank prints too much money or makes it very easy to borrow money by keeping interest rates low, then prices will rise. Events like wars that cause a shortage of goods can also increase prices.

Rising prices

So, a little bit of inflation doesn’t really hurt anybody, but when inflation is high and volatile and when it’s unexpected, it can do a lot of damage to the way a capitalist system runs. It can make planning very difficult. It can make borrowing money and lending money very difficult because you don’t know how much you’re going to get back.

And so, in countries that suffer high inflation, you see a breakdown in long-term borrowing. To avoid extremes of inflation, most central banks try to keep it at around 2%. To stop inflation from rising, they can increase interest rates making it more expensive for everyone to borrow money, which slows the economy and lowers inflation.

Predicting when central banks need to intervene to curb inflation used to be pretty straightforward. Thanks in part to observations published in 1958 by an economist from New Zealand called A.W. Phillips. He is a trending resourceful man as a schoolchild. For example, he rebuilt a truck from scratch and drove it himself to school, taking his friends along with him. He was also a prisoner of war during the Second World War and famously created some secret radios and tea heaters.

Phillips observed that wages in Britain tended to rise faster if employment was high. He plotted the relationship between salary rates of change and unemployment levels to produce what is known as the Phillips curve. This curve was used by central banks to help predict inflation.

As if lots of people worked and wages were rising, it tended to lead to price increases. If unemployment’s low and wages are therefore rising faster, that puts upward pressure on costs, and firms will feel confident passing those higher costs on into higher prices because the economy is presumably doing quite well.

The opposite is also true. When the economy is weak and unemployment is high, wages stop rising, and firms can’t raise prices much without losing customers. This theory was pushed to the extreme in the 1970s.

A spike in oil price and overspending to fund the Vietnam war meant that inflation was rising rapidly in America. So Paul Volcker, the Head of the Federal Reserve, raised interest rates to a record – 20%. This huge hike in interest was known as the Volcker’s shock and brought inflation down by the 1980s. It created mass unemployment in the U.S., but it did ultimately have the effect of curbing inflation, and as a result, inflation did come down from double digits.

But the idea that ups and downs in employment explain changes in inflation didn’t last, giving rise to one of the great economic conundrums of the modern world. The global financial crisis of 2007 to 2009 caused mass unemployment in America, but strangely, inflation didn’t fall very far, and as the economy recovered and unemployment reached a 50-year low in America in 2019, inflation remained mysteriously low baffling economists and politicians alike.

Some economists declared that the Phillips curve was dead, but we think a more mainstream view was that it was merely hibernating. This mystery of low inflation led to a radical rethink about what was causing prices to stagnate.

One explanation is that central banks have kept inflation low for so long that people no longer expect inflation to rise even in a jobs boom. And firms are more reluctant to raise their prices or wages if they don’t expect anyone else to do the same.

Another theory is that globalization has helped keep prices low because it’s led to an influx of cheap imports. Central banks have run out of room to cope with globalization because interest rates have been so low since the global financial crisis and so if you do get downward pressure on prices from, for example, manufactured imports from emerging economies, central banks don’t anymore have the room to offset that by allowing other prices to rise faster.

Other economists say that because firms didn’t cut wages much during the financial crisis to protect worker morale, they didn’t raise wages much during the recovery, and this slowed inflation. Pay and inflation would eventually rise, but it would take time. And before inflation had the chance to correct itself, the pandemic hits.

But an unexpected outcome of the disruption caused by the pandemic might actually help raise inflation and get it back on track. The pandemic has led to far greater cooperation between central banks and governments. As central banks have printed money, governments have offered stimulus packages ensuring that people are able to spend it.

If governments can borrow and spend in the knowledge that they won’t put upward pressure on interest rates because central banks will stop that from happening, then that should be quite a powerful stimulant to the economy. This cooperation could not only be enough to pick inflation up off the floor, it could also help repair the global economy.

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