Explainer: The Return of inflation in the developed world bl-premium-article-image

N Madhavan Updated - November 22, 2021 at 05:30 PM.

Post Covid pandemic, inflation has started to rise, bringing memories of the 1970s when price rise was a major challenge

 

Why is inflation suddenly a matter of concern in the developed world?

For many decades now, inflation has remained very low in evolved economies. In the 2010-20 decade, it remained lower than 2 per cent. In fact, if media reports are to be believed, a third of the people who live in the developed world today have not seen average inflation exceed 5 per cent in their life time. Such being the case, governments and central banks have taken inflation for granted, cut interest rates to almost zero and borrowed heavily to fuel economic growth (rich world’s public debt is 125 per cent of their GDP and still no one is alarmed).

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Post Covid-19 pandemic, inflation has started to rise and that is bringing memories of the 1970s when price rise was a major challenge. In 1975, inflation was as high as 24 per cent in Britain. The average inflation that decade in the developed economies was 10 per cent.

How sharp has been the rise in inflation?

It has been quite significant, indeed. The Consumer Price Index in the US rose by 6.2 per cent in October this year compared to last year — highest in three decades. The European Union’s inflation at 4.1 per cent in the same month was a 13-year high and more than double its well-enshrined target of 2 per cent. The UK’s inflation too is a decade high at 4.2 per cent.

How are the central banks in these economies reacting?

The US’ Federal Reserve (Fed) is maintaining that this inflation is `transitory’ and caused by supply-chain bottlenecks created by Covid. It expects prices to come down next year once supplies improve. European Central Bank (ECB) too has taken a similar stand. Both have ruled out any immediate increase in interest rates to tame inflation as that could smother the fledgling economic recovery post-Covid.

However, with inflation remaining firm in the US, Fed is under pressure to act. It has announced that it will reduce its bond purchases that ensured a loose monetary policy. This process could get accelerated if inflation remains sticky and could be followed by interest rate hikes sometime next year. In the meantime, the Biden administration’s popularity has taken a beating on account of price rise.

How will high inflation in developed countries impact emerging markets?

Persistent high inflation will force them to increase interest rates and such a move may impact emerging markets, including India. Foreign portfolio investors pumped in as much as $37 billion into India in FY21 alone in search of better returns. Increase in interest rates in the US or Europe will cause some of them to shift to those markets. This could trigger a sell-off in the markets (remember the taper tantrum of 2013!).

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Taking advantage of low (or near zero) interest rates, Indian companies have borrowed as much as $130 billion in the last five years. These borrowings could turn costly and future external commercial borrowings could become unattractive. If the dollar outflow is heavy and inflow drops, rupee could come under pressure. A weakened rupee (along with high fuel prices) could fuel domestic inflation and smother economic growth.

What is the inflation like in emerging markets?

Though it is in control in India, other emerging countries are already grappling with rising inflation. Brazil’s inflation is 10.67 per cent while Turkey’s has touched almost 20 per cent. Argentina is seeing a runaway inflation in excess of 50 per cent and in Russia it is 8.1 per cent. Central banks of Brazil and Russia have already started raising interest rates. Argentina’s central bank has, so far, refused to do so despite the high inflation and Turkey chose to do the opposite — reduce the rates.

Published on November 22, 2021 09:33