The post-pandemic inflation spike: transitory or a sign of things to come?

With the pace of price rises having slowed considerably in recent months, it is tempting to believe the global inflation challenge has been addressed and overcome. But is this optimism warranted?

While the world’s major central banks have not quite declared victory in their war against inflation, policymakers appear increasingly confident they have managed to bring price rises under control. Rates are falling back close to or, in the case of the UK, in line with banks’ 2% targets. In June, the European Central Bank became the first of the ‘big three’ Western central banks to reduce borrowing rates, and the Bank of England and US Federal Reserve are expected to follow suit in the second half of 2024.

But there remains considerable uncertainty around the likely trajectory of inflation over the medium to long term. Has the spike in the rate of price rises experienced in the wake of the Covid-19 pandemic been a transitory and relatively short-lived phenomenon attributable to factors such as the unlocking of pent-up demand and global supply problems? Or does it instead herald a shift to a ‘new normal’ of persistently above-target inflation driven by demographic developments and geopolitical tensions?

The answers to these questions will have a significant impact on monetary policy and market performance in the years ahead. We spoke to two leading economists to understand their contrasting views on the future for inflation.

The inflation that followed the pandemic was in fact made up of three separate waves, and it was down to little more than bad luck that they followed each other in such rapid succession. The first wave was the result of people emerging from the Covid-19 lockdowns with high levels of savings, which led to a surge in global demand for manufactured goods that exceeded supply. But, since these savings could not last forever, this demand was transitory.

Unfortunately, just as this post-pandemic demand was peaking in early 2022, Russia invaded Ukraine and prompted a commodity-driven inflation spike – the second of the three waves. This was a war-driven supply shock and had nothing to do with a supply-demand imbalance. However, this spike faded faster than expected due to an increase in price sensitivity in energy demand – for example, after Covid, more people could choose to work from home rather than drive to work when the price of oil went up.

The third wave was profit-led inflation, when retailers told their customers they had no choice but to increase prices. In the US, retail profits as a share of retail GDP rose from 14% to 21% in two years. More recently, however, consumers have rebelled – they have worked out these price increases are not fair, and they have become more economical and less loyal in their shopping habits.

These three waves have now come to an end, but what about the future? Many economists believe that ageing populations and more limited supplies of labor will inevitably contribute to consistently higher levels of inflation in the future. But my view is that we need to rethink our understanding of labor markets – and of labor-market statistics. Yes, we are an ageing society, but how many people will really be able to retire at 65? Even after leaving our main jobs, many of us continue to contribute to the economy through volunteering, for example – and this does not appear in employment figures. Similarly, nowadays it is far more common for people to have more than one role in terms of their work – but only the main job appears in official statistics. I think that this increasing level of flexibility will help to contain inflation in the years ahead.

One of the reasons I believe there could be considerably worse to come in terms of inflation is that, to date, governments have been able to command fiscal resources to soften the blow of accelerating price rises. When energy prices for the average UK household soared, the government was able to provide an energy cap – in effect, this was a transfer of resources from the government to the private sector, which the government has to pay for through higher issuance. The question is: how many times will a government be able to do that before it hits a fiscal limit? When you reach that limit, your ability to protect consumers from inflation is a lot weaker – and that is when you really feel the brunt of inflation.

However, the main driver behind long-term rises in inflation is demography. We are fairly sure that the labor force will shrink and that part of that labor force will be required to look after the elderly. But we are less sure how quickly technology can replace workers. One theory is that artificial intelligence and automation will be able to replace workers in a wide range of fields, leading to a global deflationary boom. But is this really likely to be the case?

Imagine there is a technological shock that allows a firm to replace 50% of its human tasks with software. There will be two types of workers in the firm, one who is laid off – which initially has a disinflationary impact – and one whose skills are enhanced by the new technology, whose productivity increases and whose income increases – which is inflationary. But what happens to the redundant worker? History suggests that, as well as creating new sectors and avenues of growth, major technological innovations also enable economies to reabsorb displaced workers by creating new roles for them.

Meanwhile, although I agree that the initial post-pandemic inflation spike was caused by supply-demand imbalances, I would argue that these are likely to be a recurring feature in the future. Given the current state of geopolitics, it is hard to see a world that globalizes more from here. This means that manufacturing and service provision cycles will become more domestic, resulting in supply shortages on a regular basis. As governments become increasingly interested in looking after their own interests, global trade will inevitably become more inefficient.