Essay on Inflation
As Mark Mobius points out, inflation is a phenomenon of currency (2020) that is commonly defined as the rise in the prices of goods and services in the economy over a period of time, signifying a lower purchasing power of the currency. The rates of inflation vary based on numerous factors ranging from fiscal policy to demand and supply trends, and a rise in production costs. This essay attempts an assessment of the factors contributing to the low rates of inflation in the Euro Area, the UK and the US in the month of February 2021 as well as an assessment of the trajectory that these inflation rates are likely to take in the event that the supportive monetary policy and fiscal stimulus packages continue.
The Euro Area, the UK and the US marked inflation rates of 0.9, 0.9, and 1.7 per cent respectively in the month of February 2021. These rates are considerably lower than the inflation target of 2% which was set by the respective central banks. A moderate rate of inflation is necessary for economic growth; thus, these lower rates of inflation can be a cause of concern if they persist for a longer period of time (Sánchez and Kim, 2018). The Monetary Policy Report of the Bank of England for February 2021 states that Covid-19 has severely impacted spending, incomes and jobs. Due to the pandemic and the consequent lockdowns, many businesses sold fewer goods/services while some were unable to sell at all. Family incomes dwindled due to pandemic-induced pay cuts and unemployment. Thus, people are spending less, leading to lower inflation rates (Bank of England, 2021).
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Slower growth in the economy is also stated to be the cause of low rates of inflation (Bank of England, 2021). As people are spending less, firms tend to raise prices at a lesser rate. The GDP of the Euro Area saw a decrease of 0.6% in the first quarter of 2021 (Eurostat 2021a), as did that of the UK by 1.5% (UK Office for National Statistics (ONS), 2021a). However, the first-quarter estimate of GDP in the US increased by 6.4% (GDP|US Bureau of Economic Analysis, 2021), possibly pointing towards the slightly higher rate of inflation in the US in comparison to the UK and the Euro Area.
The month of February marked lower unemployment rates than the previous months as it dropped to 8.3% in the Euro Area (Eurostat 2021b), 4.9% in the UK (UK ONS, 2021b), and 6.2% in the US (US Bureau of Labour Statistics, 2021). According to the inverse relationship between unemployment rates and inflation that the Phillips curve demonstrates, lower unemployment rates should have paved the way to higher rates of inflation. The UK outlook review by NIESR points out the reason why inflation rates might still remain low despite lower rates of unemployment. Due to the pandemic, furloughed workers who are temporarily unemployed are still considered employed, thus reflecting lower unemployment rates. Many workers who are away from work and unpaid due to the pandemic also report themselves as employed in the Labour Force Survey (NIESR, 2021). Thus, the unemployment rates may be masking the actual level of unemployment in the economy, explaining the low rates of inflation.
Besides, developed nations have been showing low rates of inflation in general, owing to factors like globalisation and technological advancement (Sánchez and Kim, 2018). The growth and increasing adoption of technology has significantly reduced the prices of goods which employ these technologies. Technological advancement has also boosted labour productivity with useful applications and software, easy access to information and improved communication (Sánchez and Kim, 2018). This implies a significant reduction in unit labour cost and is a valid phenomenon in the pandemic scenario where employees mostly work from home if possible.
Technological improvements have led to cheaper prices of equipment, lesser need for physical shopping set-ups with the advent of e-commerce, and also the relatively new phenomenon of sharing economy as seen in services like Airbnb, Uber and Rent the Runway (Summers, 2020). They have reduced investment requirements and along with other factors like the decline in the working-age population, has led to a state of secular stagnation in high-income economies as noted by Lawrence H. Summers (2020). In the context of the pandemic, new avenues have opened up for e-commerce with regard to consumer segments and product types (OECD, 2020). This implies relatively lesser investments, which correspond to lower rates of inflation.
However, the inflation rates hold out the sign of increase through the rest of the year as there is hope for growth and recovery in the economy with increasing numbers of the population getting vaccinated. As the ECB’s statistics show, the inflation rate has jumped from 0.9% in February to 1.3% in March and 1.6% in April in the Euro Area. The central banks are supporting the economy through lowered interest rates and quantitative easing. The Bank of England reduced interest rates to 0.1% in the month of February. Cheaper borrowings are expected to encourage spending and investment in the economy. Interest rates on mortgages and business loans are also maintained low through the acquisition of government bonds in large quantities by the Bank of England (Bank of England, 2021). Similarly, the US Federal Reserve maintains short-term interest rates near zero through the acquisition of at least $120 billion of bonds each month despite inflation being already on the rise as of April 2021 (Cox, 2021). Judging by the quantitative theory of money, these measures are bound to increase the supply of money in the economy as well as the speed at which money circulates in the economy. With the prospects of life returning to normal as more and more people are getting vaccinated, the rise in the confidence of people will also lead to more borrowing, spending and investment. As noted in the transcript of the press briefing by the IMF in April (2021), the continued financial support in large economies like the US are expected to put economic growth back on track even if it is at a slower pace in economies than the Euro Area, eventually leading to a rise in inflation rates.
Unemployment rates also continued to fall in the months past February and stood at 8% in the Euro Area (Eurostat 2021c) and 4.7% in the UK as of April (UK ONS, 2021), and at 5.8% in the US in May despite an increase to 6.1% in April (US BLS, 2021). These rates are also likely to push inflation higher as family incomes would also increase correspondingly. These rates are expected to continue on the rise if the pandemic remains at bay and does not bound back with a third wave.
To conclude, the impact of the pandemic in reducing spending, incomes and jobs, the consequent slow economic growth, and the generally low rates of inflation in advanced economies in the recent years owing to factors like technological advancement are assessed to be the factors resulting in low inflation rates in February 2021 in the Euro Area, the UK and the US. These rates show a strong possibility to rise through the rest of the year and reach the inflation target of 2% given that the strong fiscal support extended by the central banks continues, helping the economy overcome the blow of the pandemic.
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Bank of England (2021), Monetary Policy Report – February 2021. Available at: https://www.bankofengland.co.uk/monetary-policy-report/2021/february-2021 (Accessed: 14 June 2021)
Cox, Jeff (2021) ‘Fed holds interest rates near zero, sees faster growth and higher inflation’. CNBC. Available at: https://www.cnbc.com/2021/04/28/fed-holds-interest-rates-near-zero-sees-faster-growth-and-higher-inflation.html (Accessed: 16 June 2021)
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