The answer to inflation fears lies in ending Covid disruption
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The writer is chief economist of G+ Economics
Covid-19 has upended traditional economic theory. After a year of panic about persistent growth disruptions, markets have been forced to come to grips with a new and unexpected source of volatility — persistent high inflation.
The sharpest contraction on record has given way to a major stock market rally and the steepest global inflation shock since the 1970s.
The only way to understand this rollercoaster of economic risks is to recognise that the Covid cycle has been driven by extraordinary supply-side shocks, as opposed to traditional demand-led forces.
What’s more, the pandemic has accelerated structural changes to global supply infrastructure, consumption patterns, labour dynamics and public sector balance sheets. The effects of these forces will be with us long after the inflation momentum of the economic reopening has faded.
In the era of low inflation, especially since the financial crisis, it’s been common for policymakers to ignore the supply side and worry solely about output gaps, based on economies’ expected deviation from estimates of potential growth, as observed through the lens of spare capacity in labour markets.
This approach works well when whole-economy output capacity is constant, consumer spending patterns predictable and macroeconomic outcomes forecastable. But this has not been the experience during the pandemic.
The peak of the recession in 2020 coincided with the wholesale closure of businesses, travel and education. Companies froze orders, reduced staffing levels and ran down inventories. The result was widescale disruption across supply chains, labour participation and investment planning, leading to a slow restoration of production capacity through the subsequent economic reopening.
This has meant disruptive structural changes to production, delivery, storage capacity across sectors on a global scale, right down to industry supply chains. Evidence of this has been clear in delayed mining operations, semiconductor shortages, clogged transportation, surging freight costs, port congestions, quarantine restrictions and trade processing backlogs.
Thus, current inflation numbers were born in the deepest, sharpest recession in history. Traditionally such downturns would prove deflationary through the forces of economic uncertainty, higher unemployment and spare industrial capacity. Instead, the processes of mass-scale disinvestment during the peak of the pandemic’s economic pain has led to supply disruptions driving up prices in areas from chips for auto touchscreen displays to lumber for home construction.
Similarly, the spike in unemployment rates caused by the Covid growth shock has proven far from deflationary, in contrast to traditional recession cycles. Enhanced unemployment insurance, school closures and health risks have limited labour participation below pre-pandemic levels. These supply-side factors have — at least in the short term — pushed up wages, especially in those sectors worst hit by the pandemic, such as catering and hospitality.
But the economic effects of Covid-19 do not end with the supply-demand imbalances of the past year and a half. The pandemic has accelerated structural changes to business models, consumption patterns, labour dynamics and public sector balance sheets.
Disrupted supply chains have forced businesses to reshore production capacity. The lockdowns also have further spurred the digitisation of interactions between businesses and customers as well as supply-chain connections. In addition, remote working has increased business use of advanced cloud and online technologies.
As new business models are adopted, old jobs are destroyed. There will not be a return to normal. Labour markets will be divided between those workers who are reskilled and retooled for the jobs that have been created by the pandemic, and those who are not. The result is likely to be some labour markets that are too hot in terms of demand from companies for employees with the right skills and some areas where the supply of workers is too much.
The K-shaped inequality in household incomes and wealth created by the pandemic will become even more apparent once Covid-related fiscal transfers end in the coming weeks.
The structural legacy of Covid-19 will be with us long after the sugar rush of overstimulation of the economy by central banks and governments at a time of pent-up demand and restricted supply capacity has faded from view.