Central bankers pray the inflation surge is temporary, while others fear it will last

For those who think that it never rains but it pours – not a bad description of this English summer so far – the fact that we have lurched from deep worries about the economic impact of the pandemic, to fears that the recovery from it is bringing inflation, just about sums it up.

Milton Friedman once said that “inflation is always and everywhere a monetary phenomenon”, of which more in a moment. But, to paraphrase Friedman, inflation is certainly everywhere at the moment. It is there in house prices, rising by more than 13% annually in June, according to the Nationwide Building Society.

It is there in consumer prices index, already back above the official 2% target and set to reach 4% before the year is out, according to Andy Haldane, the Bank of England’s outgoing chief economist. America’s inflation rate has already hit 5%.

Inflation is also in the pipeline, literally when it comes to a soaring oil price and in another official measure of inflation, producer prices. Industry’s input prices are showing an annual rise well into double figures, while output prices are recording an inflation rate of nearly 5%.

Or, look at the surveys. The latest UK purchasing managers’ survey for manufacturing reports costs rising at the fastest rate in its 30-year history, for the service sector both cost inflation and prices charged were at record highs, while for construction severe shortages of products and materials also resulted in record price rises.

These surveys have not, it should be said, been running long enough to enable comparisons with the great inflations of the 1970s and 1980s, but the point is made. Costs and prices are under a lot of upward pressure. The question is why it is happening, and where the process may come to an end.

There are three reasons why inflation is rising and has become an issue. The first fall into the category known by economists as “base effects”. These are quite easy to understand. If prices were exceptionally weak a year ago, then the 12-month comparison is likely to exaggerate the true inflation rate.

When it comes to UK consumer price inflation, currently as noted just above the official 2% target, these base effects are not all one way. While some prices did weaken when the pandemic first hit, particularly for products like clothing and footwear, and motoring costs such as petrol. But food prices rose quite sharply. With these effects roughly cancelling out, the base effect is not that powerful yet on consumer price inflation.

It is, however, very powerful when it comes to pay. Many millions of people moved on to furlough in spring and summer 2020, in most cases cutting their pay by 20%. The comparisons with that period of weak pay are resulting in exaggeratedly strong annual average earnings growth. With earnings growth set to hit 8%, in time for the annual uprating of the state pension because of the triple lock, this has led to a £3 billion (the additional cost of uprating) headache for the chancellor.

The second big reason for the rise in inflation are what central bankers describe as temporary or “transitory” effects. Some of these are closely related to base effects but others reflect the rapid turning back on of economies that were operating below normal.

These transitory effects include supply-chain bottlenecks and rapid demand led increases in raw material and energy costs. Additional complications, like the temporary closure of the Suez canal a few weeks ago, have added to the problem.

The idea of temporary effects is not just wishful thinking. This year should see the global economy grow by 6%, according to the International Monetary Fund, following a 3.3% contraction last year. The bounce is even stronger than the post-crisis global recovery in 2010, when global GDP grew by 5.4%. Inflation moved temporarily higher then, and history could be repeating itself.

These are not the only explanations for higher inflation, however, and while they are generally benign others are less so. Milton Friedman, were he alive today, would be looking at the huge monetary stimulus provided by central banks in the form of low interest rates and quantitative easing. He would also be looking at the extent to which governments have turned on the fiscal taps, both during the pandemic and in the recovery period from it, particularly in America.

In his absence, monetarists like Tim Congdon of the Institute of International Monetary Research have been warning for months of high inflation. He is not alone. Even American Keynesians worry that Joe Biden’s $6 trillion stimulus plan will inevitably mean high inflation.

Though this could also be put down as another temporary effect, history tells us that when inflation takes hold it is hard to shift. Policymakers are putting all their faith in this not being one of those episodes. But it will be a nervous time as we wait to see whether they are right or not.