Understanding inflation and Central Banks’ response

The Italian Club and Geopolitics & Business Society at LBS recently co-hosted Dr Riccardo Trezzi, Lecturer at the University of Geneva, Switzerland and former Senior Economist at the European Central Bank (ECB) & the US Federal Reserve, for a discussion on how geopolitical events affect inflation and how central banks respond to bring inflation under control.

Decoupling energy price shock and core inflation

The event began with a discussion on the key factors driving inflation and whether inflation is a result of supply-side effects, demand-side effects, commodity price shocks, monetary policy, or fiscal policy. Dr Trezzi explained that contrary to popular belief inflation is not caused by a shock in the prices of energy or any other commodity. Recent data from the US suggests that while the energy price shock did result in an increase in the cost of essentials such as energy and food, the underlying core inflation, which excludes food and energy, remained largely the same. In other words, energy price shocks do not pass through to core inflation and only affect the total inflation, making it more volatile. Dr Trezzi pointed out that even before the energy price shock caused by the war in Ukraine, the core inflation in the US was about 6% and 4% in the Eurozone. Dr Trezzi also explained how commodity price shocks lead to the transitionary effect of the total inflation varying with the price of the commodity but ultimately reverting to the core inflation as the commodity’s price stabilizes.

This begs the question – what might have caused core inflation in the US and Eurozone in the first place? Dr Trezzi stated that the main reason for core inflation in the US is the fiscal stimulus and the reopening of the economy after the pandemic leading to a surge in consumer demand but with constrained supply chains. This supply-demand mismatch drove prices up resulting in inflation. Not only was the supply of goods constrained, but global supply chains were also stressed due to geopolitical events and varying levels of recovery from the pandemic leading to negative supply shocks. The same reasons were true for Europe; however, the impact of the energy price shock was much more pronounced in Europe. The US was exposed to an energy price shock too, as domestic gas prices rose after it started exporting large volumes to the EU. However, this shock was much less severe than the one that Europe was exposed to.

Furthermore, inflation cannot be a supply-driven event alone and there must be a demand component too. The demand element comes from the labour market, which has also suffered a positive shock as many people moved out of cities and did not return to their old jobs, especially in the travel and hospitality industries, after the reopening of economies. A tight labour market has meant lower availability of skilled workers and higher wages which has increased their spending power and put further pressure on already stressed supply chains.

Responding to inflation

On being asked how central banks typically respond to inflation, Dr Trezzi remarked that there are essentially three models of inflation response – a standard fiscal response model, a physical model, and a new Keynesian model. The standard response of central banks is to hike interest rates to rein in inflation, but the key question they must grapple with is what level of interest rate will be compatible with the target inflation? There are a few theoretical models that can be trained to give that answer, and they can be calibrated by analysing past data that allows them to estimate the required rate of interest. The task of some central banks, such as the US Federal Reserve, is also complicated by the fact that they have a dual mandate – they are required to keep inflation in check as well as regulate the labour market. Thus, in some cases, central banks push the unemployment rate to regulate demand.

Role of monetary policies

Monetary policies can also control inflation, but only if they are aligned with fiscal policies. This was unfortunately not the case in Argentina, thereby resulting in very high inflation in the country. This situation can also arise in the Eurozone, wherein the ECB controls the monetary policy while each country controls its own fiscal policy. This calls for greater cooperation between the ECB and the central banks and governments of the Eurozone countries. Dr Trezzi also acknowledge that central banks all over the world have prioritized fiscal policies, such as interest rates hikes, to control inflation, thereby resulting in a fiscal dominant world. This, however, may not be the best strategy, and Dr Trezzi argued that central banks should resort to monetary policies more often.

Evolution of factors driving inflation

In the 1970s, energy prices had a significant impact on inflation, but that has changed considerably in recent years. As per Dr Trezzi, this is primarily because the economy is way less energy intensive than it used to be mostly because of emergence of the services sector. The second reason is that the consumption basket has also changed a lot – from being heavily focused on goods in the 1970s to being more service-oriented. However, there are secondary effects as most services are labour-intensive and their costs can increase in a tight labour market.

US Dollar to lose its world dominance?

Another question posed by the audience to Dr Trezzi was whether there is any chance of the US Dollar being upended as the world’s strongest currency, as there have been calls by some countries, especially the BRIC (Brazil, Russia, India, and China) nations, to come up with a new currency. To this, Dr Trezzi remarked that the US Dollar had become such a prominent currency because of prolonged strength of the US economy and the role played by the US in rebuilding the global economy after World War II. As a result, currently more than 75% of the global trades are US$-indexed. There is also a cost associated with switching away from the current system, which could be prohibitive. Thus, it would be extremely difficult for any currency to replace the incumbent. Being that said, monetary systems have been overhauled in a matter of decades – for example, the replacement of national currencies by the Euro in the Eurozone – and so, nothing can be set in stone when it comes to such matters.

Dr Ricardo Trezzi is a Lecturer at the University of Geneva, Switzerland. Prior to his current role, he worked on the inflation desk of the Federal Reserve in Washington D.C. and of the European Central Bank in Frankfurt. He holds a Ph.D. in Economics from the University of Cambridge in the UK. He is also the founder of UnderlyingInflation.com.

Sagun Tripathi (MBA 2023) worked for more than eight years in the energy sector, across different geographies – the US, Germany, and India – and functions – R&D, consulting, strategy, and operations – before coming to LBS. He is passionate about climate action and how sustainable energy holds the power to transform lives in the developing world.

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