Prices are rising: is inflation coming like in the 70s?

The reasons for the price shock at the beginning of the year are well known. If the Corona purchase backlog clears, it will be even more expensive. How bad is it gonna be Should inflation return in the long term, it would have far-reaching economic consequences.

Since the beginning of the corona pandemic, what seemed far away for a long time seems possible: a longer-term return of inflation. In January of this year, the inflation rate was one percent up on the previous month, and consumer prices rose by 0.8 percent. The prices for energy products rose particularly strongly: Compared to December, the prices for fuel and heating oil rose by double-digit percentages.

The consequences of the corona pandemic are a key driver of inflation. Two factors play a role here: On the one hand, the reduction in VAT rates that was introduced last year ended at the beginning of this year, so goods and services became somewhat more expensive again.

On the other hand, the savings rate rose significantly in Germany last year. Shops and restaurants were temporarily closed, and travel was hardly possible. If all of this is possible again after the pandemic, it could be that savers catch up on consumption from the Corona period. The resulting increase in demand could lead to higher prices – at least temporarily. Heating and refueling have also become more expensive recently, mainly due to the CO2 tax that has been due since this year.

Not a trend yet – but a price surge

"What we are now experiencing is a temporary rise in the inflation rate," says Peter Bofinger. It may also go beyond the 3 percent mark this year. "I wouldn't call that inflation," he says. "This is a price shock that can be explained by the VAT increase, CO2 pricing and the enormous collapse in energy prices last year."

The increase in inflation in January was to be expected, says Stefan Kooths, director of the Research Center for Business and Growth at the Institute for World Economy (IfW). "First of all, this is no reason to assume a trend towards higher inflation dynamics." Kooths assumes that catching up consumption will lead to a price surge that will drive the inflation rate over three percent year-on-year. "In the course of the lockdown measures, we see a pent-up purchasing power of around 200 billion euros in private households. This is consumer spending that has not been made as usual – extra savings due to corona," he says.

If the corona measures are relaxed, this purchasing power will not be fully reflected in additional demand, but part of it. "Restaurants that are then used more will use the scope for price increases," says Kooths. The same applies to tourism and entertainment offers. "If there is any doubt, stronger purchasing power will meet a smaller supply because companies have left in the wake of the pandemic," says Kooths.

Long term inflation return?

One thing is certain: if inflation should return in the long term, it would have far-reaching consequences. Because this could end the phase of low and negative interest rates – which would be unfavorable in view of the high debt levels due to the costs of fighting the pandemic.

"Whether there will be permanently higher inflation depends on whether we move in the direction of permanent financing of government spending through the printing press and whether confidence in solid public finances and stability-oriented monetary policy is damaged," says Ifo President Clemens Fuest. He doesn't expect it. The ECB has a clear mandate to ensure monetary stability, if necessary also at the price of rising interest rates and a burden on public finances. "I firmly assume that she will carry out this job," said Fuest.

Kooths assumes that there will be higher inflation rates in the medium term than in the past ten years. That has to do with three factors: the high debt positions, especially on the part of the states, the reactions of monetary policy to it and the demographic development.

"Monetary policy will probably take the high national debt into account and try to keep the financing conditions for states low," says Kooths. "Then they have to continue to intervene and buy up state papers." That meets with demographic aging, which ensures that savings decline. That in turn leads to an increase in interest rates. "If monetary policy does not reflect this to the same extent, this can result in a higher inflation trend," said Kooths.

Inflation: The 1970s

From 1970 onwards, inflation rose significantly in Germany. The first oil shock drove prices up. The lowest value was measured in 1978 with 2.7 percent and the highest in 1973 with 7.1 percent. The years 1974 and 1975 were also not price stable with 6.0 and 6.9 percent inflation. On average, the values ​​were between 3.6 and 5.4 percent. The only consolation: inflation abroad was usually much higher. (Data: Federal Statistical Office)

Peter Bofinger currently sees no signs of inflation developing as it did in the 1970s. To do this, you need significantly rising wages and a very positive labor market situation. In view of the economic consequences of the corona pandemic and the transformation of the industry, this is unlikely. In addition, there is a "post-corona world" in which people make fewer business trips, drive less often to cities, where there are fewer stationary retailers. All of this could have a negative impact on employment. "In the 1970s there was a wage-price spiral and, at the same time, a permanent rise in energy prices," he says. "I don't see either of these today."

"The friendly scenario predominates"

"After four decades of declining inflation, the tide is slowly turning, at least in the developed world," says Florian Hense from Berenberg Bank. "Several factors, both cyclical and structural, suggest that inflation will pick up in the coming years." A gradual return in inflation to central bank targets of around 2 percent could be neutral or even slightly positive for economies and real assets like stocks. In such a scenario, according to Hense, the central banks would only have to slowly reduce their stimulus measures and thus not jeopardize the economic recovery.

"However, a rapid, sustained rise in inflation beyond a level that the central banks can tolerate would force them to step on the brakes at some point," says Hense. In his view, rapid, sharply rising financing costs and the associated collapse in economic growth would be "a recipe for a major sell-off on the stock markets". But for 2021 and 2022, the friendly scenario is expected to prevail.

"Ultimately, the developed world may gradually return to the old normal before the 2008/2009 global financial crisis: less subdued inflation, faster growth in GDP per capita and productivity, and higher central bank and bond yields," says Hense.

Additional burden on national budgets is possible

Whether inflation will return in the euro zone in the long term depends on the further course of the pandemic and the possible fiscal policy reaction, says Alexander Kriwoluzky, Head of the Macroeconomics Department at the German Institute for Economic Research (DIW).

"If inflation were to return, this would mean, on the one hand, that monetary policy in the euro area would normalize again, which means that bond purchase programs would no longer be necessary," says Kriwoluzky. "That would be a great relief." On the other hand – according to the economist – inflation would lower the real debt burden and thus help indebted households, companies and countries.

"On the other hand, higher inflation numbers would go hand in hand with higher nominal interest rates," he says. "The higher nominal interest rates together with the end of the ECB's purchase programs can lead to an additional burden on the national budget and increase the risk of an unsustainable debt burden, for example in Italy," says Kriwoluzky. In the long term, he expects an inflation rate of between one and three percent.

The article first appeared on Capital.de

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