COVID-19 has accentuated the global inflation problem.
COVID- 19 has caused significant harm to both global health outcomes, with border closures and social distancing guidelines impeding economic activity across continents. As the virus has waxed and waned, with countries adapting at different rates, the economic dislocation caused by asynchronous contagion across sectors ranging from manufacturing, transport, health care, and education, tourism, and a range of services spanning farmers’ markets to restaurants and bars.
Central banks have resorted to unprecedented measures, cutting policy rates to new lows across advanced economies in an attempt to attenuate the shock from the virus. Across North America, the Federal reserve cur policy rates to 0.25% and aggressively expanded its balance sheet, the Bank of England equally cut policy rates by 75 bps to 0.1%,. Meanwhile, the ECB with already negative policy rates at -0.50, opted to expand its asset purchase program. Interest rates are now at historic lows, central balance sheets continue to balloon and inflation is stubbornly low.
The trend of disinflation is cognizant of the 2000 dot-com boom and 2008 Great Financial crisis, where consumer demand exacerbated structural drivers such as the integration of global markets, financialization, and dismal productivity growth. One cannot absolve the role of monetary policy in such outcomes, but it is equally important to remember that inflation targeting and financial stability has come to form the anchor of central banking in the 21st Century.
Where next for central banks?
If interest rates have hit rock bottom and asset purchases are only yielding marginal effects to inflation outcomes, what must central banks do in other to remain the anchor for countercyclical policies design to serve as a buffer to global business cycles? There is no clear set of answers s the need to achieve the inflation target and ensure price stability remains their sole objective. Rather than argue the legitimacy of the Philips’ curve or inflation targeting and narrower objectives of stable output and unemployment, I argue in several papers and recent articles that the practice of central banking must emancipate from its narrow objectives of price and financial stability to include a longer-term vision that emphasizes a longer-term vision
In my recent book, I argue that central banks must consider achieving inflation by designing quantitative easing to at once facilitate the energy transition, support higher value-added goods, and services, whilst supporting employment for the real economy. The verdict of the effectiveness of QE has not been reached just yet, but one can credibly confirm that the liquidity infusions latent in the shifting of short term balance sheet risk to the long end of the curve suggest that it is at once indispensable to reducing risks of bankruptcy and facilitating the transmission mechanism from monetary policy to the real economy.
On the one hand, central bankers have rightly emphaises the fiscal policy in supporting macroeconomic outcomes, upskilling large parts of the population, and addressing structural impediments to economic growth that have caused productivity to lag. tale France for example, amidst protests over labor market and pension reforms, President Macron leveraged private equity to finance R&D activity and the number of women employed in R&D-intensive roles equally rose during this time. So whilst the structural reforms have taken hold, their distributional effect has followed the skill distribution across french society. Quantitative easing should prioritize the purchase of assets that have a long-term dividend for both financial stability, output growth, and price stability. On the one hand, central banks are mandated to achieve price stability and stable output.
The question remains, should the central banks target inflation even as this measure is driven by oil prices and fluctuation in the exchange rate in developing market economies. Helen Rey pointed out that core inflation might be a preferable measure to headline inflation that is susceptible to exogenous shocks and increasingly contingent on the weight attributed to anyone good in the basket of goods and services. I have previously argued that central banks should rethink their inflation target, but this is even more prescient as inflation is at multi-year lows and depressed demand suggest that it is unlikely to see significant support from interest rates. It is important to note that, such a reassessment does not require them to lower the inflation target, but rather opt for variation bands, which increase the agility of monetary policy.
The need to target more effective measures of underlying inflation is equally consistent with an approach whereby the latter determines forward guidance, not least the future path of interest rates. Admittedly, such an outcome is more relevant if central banks are able to properly gauge underlying inflation as this captures the demand-boosting effects of inflationary outcomes. For advanced economies, the inflation problem has been accentuated by COVID-19, which has depressed oil prices and consumer demand. In the chart below, one sees that the ECB has to contend with negative inflation, driven by the contraction in economic activity and consumers opting to save rather than consume during this period.
Figure 1: COVID-19 dents Euro Area Inflation
As COVID-19 morphed into a global pandemic, inflation in the Eurozone began trending downwards. As governments imposed lock-down and social distancing measures, demand for goods and services such as food, beverage, communication as well as business and consultancy services moved online. To put this into context, E-commerce in Europe rose by 13% to 621 billion euros in 2019, showing that consumers prefer to buy cinema tickets, bus and train tickets, apparel, and communication services online. The European E-commerce report equally projects a further increase in electronic buying and trading to 717 billion euros.
Figure 2: COVID-19 has amplified the adverse effects
After years of a steady increase in retail sales, the 2008 Great Finacial Crisis interrupted this trend. This trend reversed until mid-2013 the level of retail sales has been rising steadily ever since. This was accompanied by accommodative monetary policy and a recovery in prices that saw inflation converge towards its 2.0% target. With the Covid-19 crisis and national health prevention measures setting in during the Spring of 2020 the retail trade saw an unprecedented decline in March and April 2020.
In the subsequent month, retail trade recovered almost as quickly as it had fallen and by autumn 2020 the pre-crisis level had been more or less been regained. In September 2020, total EU retail sales decreased by 2.0 % compared with August 2020, which suggest that while households were consuming from their homes, technological advances and the democratization of the market place via online sales have placed renewed downward pressures on prices across the EU.
What is negative inflation?
Neg inflation is deflation in the short-run. In other words, it can be described as a sudden slump in price levels caused by an exogenous shock. In the context of the world today, COVID-1ç constitutes a shock to inflation across the EU. This trend has been accentuated by increased digitization and E-commerce. ven as the ECB has expanded its QE program and lowered the interest rates in targeted Longer-Term refinancing operations, not only has inflation undershoot its mandated target, prices have actually fallen for the first time since fears of deflation plagued the continent during the sovereign Greece crisis.
Some have argued that the fragmentation that exists in the single market today and the heterogeneity of shocks have caused an uneven recovery. Meanwhile, fiscal responses have emphasized protecting vulnerable employees, rather than boosting productivity that results in sustained wage growth. At present, it is premature to conclude that the Eurozone is experiencing deflation, but one can link the inflatioàn problem to a hyper globalized market place and deferred consumption from COVID-19.
The central bank will continue to adjust its tools as needed in order to ensure inflation converges towards its two percent target, whilst ensuring that the economy equally recovers. It should equally be noted that the linkages between money supply persist, even as the effects are less felt in the last decade. The ECB will keep monetary policy accommodative, but the inflation problem it faces, like most central banks across the world to varying degrees, is structural and event-led.
- . ECommerce Europe. (2020) European E-Commerce Report. Europe, European Union.