Transitions come with price volatility, but policies set inflation

Getting to grips with just where the global economy stands remains a challenging task with pandemic related frictions still present. We see the effects hereof in the activity data, survey data, labour market data … but it is inflation that has drawn the most headlines, standing today at 7% in the United States and 5% in the euro area.

Breaking down the drivers behind these multi decade high inflation numbers, energy prices top the list. In the initial phases of the crisis, a slump in demand caused prices to fall sharply. Prices subsequently recovered with economic reopening and targeted measures to cap the supply side. Technical supply outages and geopolitical headwinds have recently added further upside pressure to prices. Looking ahead, even if energy prices remain at the current high levels, base effects will gradually ease, lowering the contribution of energy prices to headline inflation.

Supply side frictions, be it stoppages in key parts of the global supply chain, such as semi-conductors, transportation bottlenecks, commodity shortages or labour market frictions, have further contributed to price pressures. Although these frictions remain elevated, we observe some easing and expect further easing to come barring a new escalation of the health crisis. On this front, it is further worth note that many businesses are investing to strengthen supply chains and limit such risks in the future.

Energy prices and supply side frictions do not explain the full inflation picture. Indeed, business managers have also had to juggle the exceptional surges and shifts in pandemic driven goods demand linking in also to the stop and go of social distancing measures. These effects are also easing as social distancing measures have become better calibrated and both businesses and households have adapted.

Finally, we note the special situation of the US where an outsized fiscal poly response to the crisis triggered a surge in household incomes. This effect is, however, now fading and the overall policy stance is tightening, aided also by the measures signalled by the Federal Reserve.

Our central scenario is for many of the current inflation pressures to ease, which should see inflation return to levels closer to central bank targets over the course of the coming years. There is also a longer-term debate and not least whether the climate transition could drive structurally higher inflation. While we do see price volatility ahead as sectors shift, an orderly climate transition, based on policies fostering investment, education, new technologies and also reaping the benefits of digitalisation, should secure moderate inflation and a favourable growth environment. Indeed, it is policy that decides whether temporary price shocks become permanent inflation. This time is no different.