The Threat of Post-Covid Inflation

As you’ve probably seen in the news, inflation rates are soaring in the UK (Oct. 4.2%), US (Oct. 6.2%) and Europe (Oct. 4.1%). Although there are many other pressing economic issues, this one seems to be getting the spotlight. This is, of course, due to its potentially severe effect on our daily life. The rise of the inflation rate has been due to multiple reasons:

 

  • The rise of energy prices, for instance, by 16% in the UK (October).
  • Shortage of critical materials for both home builders and technology producers reliant on semiconductors.
  • Demand shifting from services to goods such as home appliances, equipment.
  • Rise in travel demand post-Covid.

 

All factors combined have caused demand to outstrip supply across the economies of the UK, US, and Europe, leading to the obvious outcome of inflation. However, will this lead to a wage-price spiral where workers experiencing high inflation will demand higher wages, leading to a detrimental impact on the economy as it did to multiple economies in the 1970s?

Opinions vary but let’s take history into account. If we look at the causes of the rise in the inflation rate that led to the wage-price spiral in the 1970s, it is clear that we are dealing with a different scenario. The inflation rate was mainly due to the oil embargo implemented by the Organization of Petroleum Exporting Countries (OPEC). A second surge was caused by a decline in oil production due to the Iranian Revolution and the Iran–Iraq War. This shows that we can’t look at the 1970s as an example, but rather, we need to find another inflationary period.

To our good luck, history has a lot of examples that match our scenario where the cause of the inflation is a pent-up demand together with a disruption in supply. The most relevant example is the period after World War 2, taking the US as a case study. Supply was disrupted as suppliers concentrated their manufacturing capabilities on military production. Today we face the same issue whereby a crisis has inhibited production. Demand rose in the post-war period because most goods were rationed during the war and people saved a lot of money. They were able to spend their money after the war and the purchase of goods boomed. Similar to now, people’s savings increased when they were cooped up in their homes, and now retail sales are booming. The only difference is that the US had price controls that restricted price increases to 30%.   After the government removed the price controls, prices rose immediately by 16%.

As such, we can use the post-World War 2 inflationary period to predict what’s most likely to happen. The inflation rate returned to normal levels as domestic and foreign supply chains returned to normal and demand leveled off. Of course, 1940s economies differ from modern economies, but comparing our crisis to that of the 1970s is a misleading comparison. Economics isn’t meteorology, however, so far, we haven’t experienced any symptoms of wage-price spirals as documented by Bloomberg. Therefore, we can safely assume that the probability of a wage-price inflationary spiral causing havoc to the economy is very low.