In such a scenario it is likely that the inflation in the US is mostly driven by the demand side, whereas in the UK and Europe it is mostly supply side – although labour shortages are creating supply-side pressures in the US.
Economies are driven by supply curves and demand curves. In a perfectly functioning economy, the lines would be arcing gently upwards roughly in tandem with each other, as supply and demand are roughly in sync.
Supply and demand
Supply-side inflation is caused when the demand curve is steepening at a faster rate than the supply curve. For example, when economies opened up after the initial lockdown, consumers (the demand curve) began spending quickly, but many businesses (the supply curve) found they could not quickly access stock as production had been halted. This meant prices rose due to a shortage of supply, not an excess of demand, as is more typical.
Supply-side inflation is often short-term in nature, as when businesses realise there is robust demand, they increase production.
This is one of the reasons why Azad Zangana, senior European economist at Schroders, says the present very high level of inflation in the UK will peak in April of this year, when energy prices rise sharply and then begin to fall back in Autumn.
He says the central bank’s present stance, signalling that interest rates may need to rise multiple times this year and next, may prove excessive as the supply-side issues are resolved.
He notes: "Central banks themselves are saying they still expect inflation to fall back to below 2 per cent this year or early next, so why are they so focused on rate rises?"
Banking on it
LGIM's Carrick says one of the issues for central banks is that China and other Asian countries are presently pursuing “zero Covid” policies, which mean restrictions such as factory closures. These are likely to extend the supply shortages or, in economic terms, mean the supply curve does not steepen, even as western countries open up, causing the demand curve to steepen.
The problem faced by central banks is that higher interest rates are designed to control demand-side inflation. This happens because if the interest rate available on savings rises, it may encourage people to defer spending. While if the rate of interest on borrowing rises, this means people will have to spend a greater amount of their income on debt repayments, reducing their level of spending in the economy.
But higher rates do not help to fix supply-side inflation, and may serve to exacerbate it as the cost to a company seeking to expand production rises.
Gerard Lyons, chief economic strategist at Netwealth, says that while central banks cannot expect interest rates to address supply-side shocks, what they are hoping to do is prevent the short-term inflationary pressures on the supply side of the economy turning into a longer-term issue via a rise in demand-side inflation.
