Increasing inflation is a concern for the world and the United States. However, there are ways to avoid an inflation crisis. Monetary policy, institutional reforms, and energy price shocks can all help prevent inflation.
Monetary policy
Changing monetary policy can have an important effect on inflation, output, and unemployment. However, lags between policy action and the real economy are variable and can take up to three years to manifest.
One way monetary policy is transmitted to the real economy is through the interest rate channel. This is often termed the “policy rate.” Usually, when a central bank tightens its monetary policy, its policy rate rises.
Another way monetary policy is transmitted to the real economy is through the “finance” or “money” channel. A central bank can increase its money supply by creating a new asset or expanding its current balance sheet size.
Another way monetary policy is transmitted is through the “spillover effect” – the effect of an increase in aggregate demand on prices. When there is an increase in aggregate demand, firms will raise their output, increasing consumption.
COVID-19 crisis
During the past year, the Covid-19 pandemic has considerably impacted global economic and financial development. The virus is expected to continue to influence the economic environment and economic reallocation over the longer term. Inflation rates are expected to rise as a result of the virus. However, the outcome will depend on the inflation trajectory and other factors.
In the early stages of the crisis, monetary and fiscal policies worked well together to cushion the impact of the pandemic on households and firms. However, the virus has entered a new stage. The economic transition could be slower than initially envisaged due to the uneven recovery of sectors. Some countries have returned to pre-pandemic growth paths, while others face challenging conditions.
Inflation rates rose in many countries. The rise was driven by increased commodity prices and a rebound in airfares and hotel prices. However, the impact of the virus was less pronounced than initially expected.
Energy price shocks
Throughout the 1970s, energy price shocks played a central role in economic disruption. These shocks are generally viewed with alarm by the public and macroeconomic policymakers. However, they are not always one-sided.
Supply shocks affect energy prices, such as supply disruptions in oil or other commodities. These shocks also cause fluctuations in energy demand. Energy prices are typically affected by changes in demand for petroleum-based products and alternative energy sources.
The recent run-up in energy prices has been a defining factor in the euro area consumer price inflation story. Energy price increases have also contributed to record-setting business expansion.
Inflation beyond the current spike and energy price shocks challenge macroeconomic policymakers. These shocks may be more pronounced if supply volatility increases. Moreover, these shocks may raise inflation differentials.
Disinflation in the goods sector
This month, the consumer price index (CPI) rose by 0.3%. This represents a slight decline from the 1.2% rise seen in March. This is due to the rising price of energy, driven by recent supply shocks, and the rising price of imports. The April CPI was lower than the annual inflation rate of 8.5% in March.
During this period, the euro area was the net importer of energy. This may explain part of the spike in headline inflation.
While energy prices have risen, this does not reflect stronger aggregate demand. Instead, the tight balance of payments constraints contributes to the recent price surge.
Technological advances may dampen inflationary pressures. However, a return to normal inventory levels may still be a few years away. During this period, businesses may keep prices the same to attract customers. This may lead to a recession, but it also indicates that inflation is moderating.
Institutional reforms to reduce inflation
During the last four decades, structural reforms, improved fiscal frameworks, and a robust monetary policy have played an important role in reducing inflation. These factors have kept inflation low until the current spike. However, some factors have contributed to the current spike in inflation.
One factor contributing to the current spike in inflation is the rapid rise in commodity prices. This has led to higher import costs for critical consumables. The rise in commodity prices has also pushed up the cost of funds and increased the interest rate on loans.
The OPEC 2020 decision to reduce production has also impacted the crude oil markets. There has also been a disruption in the global supply chain due to the conflict between Russia and Ukraine. This has created unexpected shortages and has added to the pressures on prices.