What is causing inflation?

If you ask Google/Twitter/Any Newspaper … the answer appears to be “Ukraine”.

This seems disingenuous: how can one conflict in Ukraine cause the highest rate of inflation since 1982?

BBC/ONS June 2022

Economists understand inflation to be caused by one of two things:

1. Demand side factors. 2. Supply side factors.

  1. If there is “too much” demand and not enough supply of goods, the effect of the excess demand is to force prices upwards. This is how the market mechanism deals with or tries to get rid of the excess demand.
  2. Supply side factors: this is the other side of the coin: if there is a lack of supply, then supply cannot meet demand so again prices are forced upwards. The rising price is a solution to the problem of excess demand or lack of supply in that it either incentives demand to drop back, or encourages firms to (eventually) supply more.

Another way to look at the supply angle is to think that firms will only supply goods and services at a higher price. So, for example, if business costs (cost of raw materials, cost of labour) are rising, then the business will only be willing to supply at a price which covers these rising costs.

So what has Ukraine got to do with this?

The effect of the conflict has been to raise the price of oil, gas and food — as supply of these goods has dropped. We can see this effect on a simple diagram: a lack of supply causes the short run aggregate supply curve (SRAS) to shift left from SRAS 1 to SRAS 2 showing that there is less available supply at every price level. This forces up the price level from P1 to P2.

(The SRAS curve models the relationship between aggregate supply and the price level, not the price of one or two goods).

But this is not the full story for a number of reasons:

  1. Inflation is a measure of the average price level across the economy — not just oil, gas and food. It includes the prices of the everyday, average basket of goods purchased by the average household. (ONS) . Oil and gas feed into these prices of course, but they are far from the full story.
  2. Inflation had begun to increase — and exceed its +-(1%)2% target — in 2021 — prior to the Ukraine conflict.
  3. The Ukraine explanation ignores the demand side of the story.

There are other supply side issues that have appeared with some ferocity since the end of the pandemic: Labour is in short supply. Some people have not returned to work after the pandemic, perhaps due to long term illness or early retirement. Brexit of course has also played a part. As a result, we now have record numbers in employment and record vacancies. The labour shortage at airports, for example, has very much been in evidence as operators have been forced to cancel thousands of flights.

Labour shortages make it harder for businesses to supply their goods — again causing a leftward shift in SRAS as shown above. They also place upward pressure on the wage rate — so business costs begin to rise which, if they can, businesses will pass on to the consumer in the form of higher prices. So there we have another cause of rising prices. In addition, a weakening pound causes import prices to rise, and, since we do import a lot of our goods (eg almost half of all food), this is yet another source of widespread price increases.

But there’s still the demand side to consider.

Many Economists — including one of the most famous, Milton Friedman, believe that “Inflation is always and everywhere a monetary phenomenon”. What they mean is that, ultimately, inflation is caused by too much demand chasing too few goods. And that demand is fuelled by there being too much money in the economy.

The government spent millions of pounds to support the Economy through the Covid pandemic. This included things such as the furlough scheme — and this was required to maintain living standards whilst the economy was shut. This spending can be seen in government spending and borrowing figures:

Source: Government Spending Review
Source: ONS

So it could be said that government spending has fuelled inflation as Aggregate Demand (total spending in the Economy) shifts to the right from AD1 to AD2 and causes the price level to increase from P1 to P2:

Government spending is not the only component in Aggregate demand. One needs to consider consumer, firm and export expenditure too. But, as one might expect, these both suffered in the pandemic and are only just recovering their pre pandemic levels.

What else might be at play?

After the financial crisis of 2008, the Bank of England began an unprecedented programme called Quantitative Easing. This was echoed in Europe and the USA. At its simplest, the government printed money. And it was a significant amount:

Source: Bank of England

According to Friedman, this should have caused inflation. Indeed, one of the reasons for the programme was to ensure that, in the aftermath of the financial crash, we did not suffer deflation. So, to that effect, it did work. But inflation stayed at 2% on average. It was not as inflationary as some feared. It did not cause there to be a significant increase in aggregate demand.

Where did this money go? It did not go directly to consumers — there was no “helicopter money”.

The money is probably the cause of rising asset prices: as can be seen here in house prices:

And maybe here in the FTSE250 which captures what has happened to share prices:

Source: Money Week

So — some prices rose, possibly as a result of QE.

2 questions arise -

  • Are we only now seeing the effect of QE, on inflation? Why would that be? Through what mechanism is the programme of QE now feeding into measures of everyday inflation?
  • Could it be the case that the reason QE was not as inflationary as first feared, because of a very elastic, easy supply side environment? Looking at our aggregate demand and aggregate supply diagram, we can see that an increase in spending — in AD — is only inflationary if that demand cannot be met by supply. If supply is plentiful, then there is no reason for price to increase. Prior to the pandemic, a seemingly endless supply of goods (think Amazon) and labour (pre Brexit) lulled us into a non inflationary environment. Demand is only in excess if there is a lack of supply.

In this sense an explanation of our inflationary predicament begins to emerge. The Bank of England and the Treasury pursued policies which increased aggregate demand on the assumption that supply would continue to accommodate this increased demand as it did in the years prior to Brexit and Covid and the war in Ukraine. Once these latter developments kicked in, the assumption that increasing money supply was not inflationary broke down. As global supply chains snarled up and Britain lost access to cheap labour from the EU, the aggregate supply curve went from being relatively elastic to being relatively inelastic. The result has been rising prices.

What is remarkable is that the monetary authorities never saw this coming. Did their models not include for the effects of leaving the EU or for the damage to global supply networks? And did they not think what would happen to global product prices as the whole world printed money to cope with Covid? It seems not.

So now we are in a pickle! The rate of inflation can only fall if either demand falls or supply rises. Given that we are near full employment and productivity is stagnant and the effects of Brexit on labour supply are not going away, a sudden shift outwards in aggregate supply, despite what people like Liz Truss claim, seems very slim indeed. Which leaves cutting demand — which means higher interest rates and increased taxation. The inflation of the 1970s was only purged from the system by the Conservative recession of the early 1980s. It would seem that is where we are headed. Whoever emerges as the next Tory leader is going to have a very short honeymoon.