The reasons of rising inflation

Author: Joost Haddinga                                                                                                                                                                                November 25, 2021

A byproduct of COVID-19 or the entrance into a new era?

After years of low inflation and relative price stability we suddenly see rising prices again. Do we now have to fear the worst, are we on the brink of a new deep recession or is it a one-time event passing quickly? Let’s find out more about the reasons behind the currently increased price growth.

Car owners were concerned in the last weeks: Gasoline prices kept rising and eventually reached heights of more than € 2 per liter – making gas as expensive as it last was in 2012. Furthermore, the whole economy showed signs of price increases as in September 2021 the inflation rate (compared to the year before) reached 3.4 % according to the harmonized consumer price index (HCPI) on an EU-wide basis - the highest value since the Financial Crisis of 2008. While the Netherlands (+ 3%) weren’t struck quite as badly as countries like Germany (+ 4.1%) or even Poland (+ 5.6%), this increase still represents a value way above the price stability target of 2 % inflation p. a. of the European Union.

Inflation itself means that money loses value – or purchasing power – over time, such that you can eventually buy less goods with the same amount of money. Mostly this happens as central banks keep increasing the money supply at a rate above the economic growth and more currency stands against a constant number of goods, hence driving prices up.

Currently, exactly such mechanisms are in place and we experience both inflation from a supply-side and a demand-side perspective as consequences of COVID19 and the stimuli pursued by many governments to help the economies. A lot of money was pumped into the system – more than € 2 trillion in the EU and $ 2.5 trillion in the US alone, which flowed mainly into savings at the first instant and is now creating excess demand with economies reopening again. Thus, a large factor for inflation is a mismatch between supply and demand. During the COVID-19 pandemic many global supply chains broke down or were at least diminished as less goods were traded and demanded in 2020. Given the stimuli mentioned above, spending resuming to previous levels and demand further soaring, many companies face shortages of products or components. So some car factories in Germany were forced to stop their production as they could not get their hands on computer chips. Likewise, in some Asian countries production is still frequently halted because of COVID-19 outbreaks. 

Such supply bottlenecks cause inflation of producer prices as suppliers might already charge more to deliver components quickly or in a higher number than usually demanded and producers then pass on these higher prices to consumers. These developments were further increased by rising oil and commodity prices: Hence components did not only get more expensive because of more demand for them or scarcity, but also because they themselves were more expensive to produce. Especially rising oil prices are a story of high demand: Whereas they reached all-time lows at the beginning of the pandemic when travels were abandoned and only little oil was demanded, now that people want to travel and spend again they jump up – which is further reinforced by new taxes levied on gas and oil in favor of promoting the use of renewable sources.

According to ECB president Lagarde the increase of German VAT back to 19 % after it was temporarily decreased in 2020 to 16 % further added to the inflationary tendencies across Europe.

Finally, the risk of entering a new period of stagflation – that is continued inflation without economic growth - is rather minor, says German economist Karl-Heinz Paque. He anticipates that the current supply shortages and breakdowns of production will be alleviated over time by the markets themselves when restoring their normal functioning and that currently high prices are mainly the cause of demand stimuli run by governments across the world. Hence, consumers should not need to be anxious about prices rising at a constantly high rate in the future – only car drivers and those relying primarily on fossil fuels may need to get used to permanently high prices as the world continually transitions away from these products.

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