Contribution Inflation has different colors, and so does monetary policy
By Stephen Lee
Stephen Lee is the chief economist at Meritz Securities, Seoul. Courtesy of Meritz Securities
Central banks are moving fast where there is demand-driven inflation
Inflation is now everywhere, is QE to blame?
Currently we are observing inflation numbers that we haven't seen for decades. Consumer price inflation (CPI) growth (12-month change) topped 8 percent in the U.S. in recent months, with that of the Eurozone and the U.K. reaching over 7 percent. Korean CPI growth came in at above 5 percent in May 2022, which is the fastest growth since 2008. What brought us here and why are central banks rushing to address inflation?
Some blame quantitative easing as the cause of global inflation, but it is not what explains inflation today. The large-scale asset purchases of the U.S. Federal Reserve (Fed) had its monetary base ― or the amount of currency in circulation and in reserves ― rise more than twofold in the past two years, but that has not led to substantial increases in broad money, a more inclusive measure of the nation's money supply. This situation implies that the money multiplier ― or the ratio of broad money to base money ― declined. Increases in broad money, to a much lesser extent than that of the monetary base, have not turned into inflation in the real economy, as the velocity of money ― which is thought to remain stable in theory ― has declined over the past decades.
Three steps brought us here
So what are the causes of today's inflation? I believe there were three steps. Step one was brought about by the massive stimulus measures right after the COVID-19 pandemic outbreak. Governments in advanced nations allowed tremendous deficits, along with coordination from central banks' monetary easing. Demand for goods swiftly recovered, and supply became constrained in the short term. Typical demand-driven inflation occurred, bringing back inflation numbers to “normal.” U.S. CPI growth stood at a mere 0.1 of a percent in April 2020. In March 2021, CPI growth came in at 2.6 percent.
Then came step two: the COVID-19-specific supply shock. In normal cases, supply catches up with the previously recovered demand and brings the economy to a new equilibrium. A key feature that differed this time was the fact that supply shrunk. During mid-2021, the Delta variant caused Southeast Asian countries to lock down, causing production disruptions. Slow ramp-ups of energy production and the Russian-Ukrainian war caused oil prices to rise further. Furthermore, in the U.S., the American Rescue Plan ― a stimulus of $1.9 trillion (mainly in direct subsidies to households, March 2021) ― enabled labor to refrain from returning to work amid the virus spread. Hence, there were shortages everywhere, from raw materials and intermediate goods to labor. Those who were in need of securing these resources desperately had to buy them at higher prices. Hence, typical cost-pushing inflation occurred across the globe, pushing producer price inflation (PPI) growth into the double digits in major countries.
The last part, step three, occurred in countries with enhanced purchasing power, countries with governments that adopted massive stimulus measures over 2020 and 2021. Typical examples are the U.S. and the U.K., where their primary government deficit-to-GDP ratios shot above 8 percent during the past two years. Consumers in these countries were able to absorb cost-pushing inflation, as their willingness to pay increased. In other words, inflation pressures from the producer side have translated well to the consumer side ― namely the second round of demand-driven inflation.
Different colors of inflation, different monetary policies
So now we have inflation everywhere, but the color of the inflation differs somehow, depending on each countries' economic circumstances. It's worthwhile to take a snapshot of recent inflation to gauge these different colors.
Let us take a look at March 2022 CPI numbers across the region. In the U.S., out of the 8.5-percent CPI growth, the contribution of core components ― excluding that of food and energy ― accounted for 4.9 percentage points. Regardless of the inflation process over the past two years, we can state that current inflation in the U.S. is mainly demand-driven. In the U.K., core components account for 5.5 percentage points among the 7.1-percent growth in the CPI. In the Eurozone, however, core components account for only 1.6 percentage points of the 7.4-percent growth in the CPI. The main factor driving inflation in the region is energy, accounting for 4.9 percentage points.
This situation implies that the Fed and Bank of England (BOE) have room to control inflation for the U.S. and U.K., while policy maneuvers are much more limited for the European Central Bank (ECB). Different colors of inflation result in diverged responses of central banks. The Fed and BOE have become hawkish over the past six months, with forecasts for policy rates to come above neutral at the end of the day. Meanwhile, the ECB is likely to conduct its first rate hike only in July and hike more gradually than its advanced nation peers.
Which choice will Bank of Korea make?
The rate hike cycle of the Bank of Korea (BOK) moved ahead of that of the Fed, with the BOK addressing asset price inflation concerns in late 2021. Now the bank's policy focus has moved to curbing inflation and that became even clearer when new Governor Rhee Chang-yong came in.
The headline and core (excluding agricultural and oil) CPI growth in Korea stood at 5.40 percent and 4.05 percent, respectively, in May, much higher than the BOK's inflation target of 2 percent. Core inflation above 4 percent can be seen as demand-driven inflation, justifying the BOK's hawkish movement toward consecutive rate hikes over the next few meetings.
But I believe we need some analysis interpreting the recent surge of core inflation in Korea. Among the 4.05-percent growth in core inflation, processed food and eating out components account for 1.74 percentage points, and are sensitive to import price pressures driven by recent global agricultural inflation. This situation implies that about 40 percent of core inflation has occurred due to “cost-pushing forces” outside of Korea. This brings a dilemma to the Bank of Korea, in my view, that Fed-style rate hikes cannot be the ultimate medication for curbing inflation in Korea. I think it's reasonable to anticipate that the BOK's policy rate will not move significantly above the neutral rate, with the rate hike cycle ending this year.
The writer is the chief economist at Meritz Securities, Seoul.