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The causes and consequences of inflation

  • Rome
  • 6 July 2023

        The data of the past 12 months speak loud and clear: inflation is back. After thirty years of relative price stability, 2022 will be remembered as the year that inflation stormed the economic stage – and it remains the focus of economists, central banks and politics. Globalization brought with it the illusion that economic growth could be financed at zero interest, convincing most that a rising demand for goods and services could be accommodated without triggering price increases. Inflation, which for years had hovered below the 2% threshold, even in the face first of zero and later of negative interest rates, seemed to have consigned the phenomenon of inflation to the history books. 

        The first signs of resurgent inflation toward the end of 2021 were written off as temporary, and were thus largely ignored by central banks, which normally intervene only where problems threaten to become permanent. The most prevalent narrative was that, as a result of the 2020-21 lockdown, consumers had initially increased spending on goods at a moment when production slowed considerably to then focus their purchasing power on services they had been denied for 18 months, e.g., restaurants and travel. The combination of spiking demand and hikes in energy prices following the Ukraine invasion forced the US Federal Reserve to introduce an initial interest rate increase in March of 2022. 

        Although this first raise was followed by many others, both in America by the Fed and in Europe by the ECB, inflation has continued to hound the Italian economy due to national protectionist policies aimed at retaking control of production chains. Geopolitical tensions have foregrounded the fragility of Western economies, which have opted for a production distributed evenly across the globe. Spurred by the need to ensure the supply of goods deemed strategic to national security, many governments have decided to incentivize a selective re-industrialization, aware that over the near term this could impact negatively both on volumes and prices.

        Thus, inflation struggles to come down and its consequences continue to be felt. First of all, expectations of higher inflation over the long term are influencing the behavior of businesses and consumers. Indeed, a recent survey revealed a full three-quarters of the world population have or are planning to reduce spending for 2023, which is having repercussions on the level of both employment and growth. Secondly, given the horizontal and non-progressive nature of this “hidden tax”, the persistence of inflation is exacerbating social inequalities and threatening to lead to social disorder. Finally, as it lowers real incomes, inflation risks raising the number of Italian families living in absolute poverty from 2 to 2.3 million, for a total of 6.4 million people.

        Such serious consequences call for rapid action. Agreement is elusive on specific solutions to bring inflation back below 2% without causing a recession. Nevertheless, the debate frequently brought out the need to increase cooperation between the central bank and the government. Indeed, the central bank can slow demand by increasing interest rates, but this will inevitably lead to a contraction in investments by businesses. Only the government can enact policies aimed at counter-balancing the effects of the credit crunch, incentivizing the investments of businesses in the awareness that technological innovation and progress are the best instruments for fighting inflation over the long run.

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