Digging into the Causes of Post-Pandemic Inflation

The onset of the COVID-19 pandemic triggered unprecedented economic disruptions globally, leading to a surge in inflation rates across many countries. This post-pandemic inflation phenomenon is characterized by significant increases in the prices of goods and services, primarily due to supply chain disruptions, increased consumer demand, and expansive fiscal and monetary policies implemented to mitigate the economic impact of the pandemic. Central banks around the world have been tasked with navigating this complex inflationary environment, employing a range of monetary policy tools to stabilize prices while also supporting economic recovery. The shift in inflation rates post-pandemic marks a critical juncture for global economies, highlighting the delicate balance between fostering economic growth and maintaining price stability.

Central Banks’ challenge after COVID-19 

Central banks worldwide faced a significant calibration challenge due to uncertainties about COVID-19’s ongoing effects on demand and supply, the robustness of economic activity, and broader inflation trends. Traditional economic models struggled to capture the unique scenario induced by the pandemic, marked by an unprecedented shutdown and rapid reopening of economies. 

INFLATION FORECAST VINTAGES, JANUARY 2021 TO OCTOBER 2022

This situation led to a reassessment of initial expectations about the extent and duration of interest rate adjustments necessary to curb inflation. For example, in March 2022, the Federal Open Market Committee anticipated the Federal Funds rate peaking at just 2.8%, reflecting a broader market underestimation of the required monetary tightening to address inflationary pressures.

US INTEREST RATES, JANUARY 2021 TO DECEMBER 2023

As inflation persisted above target levels, central banks were compelled to revise their policy tightening plans upward. This adjustment was driven by several factors, including the realization that inflation would remain elevated for longer than anticipated, the resilience of economies surpassing initial expectations, and the emergence of acute labor shortages across various sectors. These shortages were exacerbated by factors such as early retirements related to COVID-19, sectoral shifts leading to skill mismatches, and reduced immigration, prompting many firms to offer substantial wage premiums to attract workers.

Moreover, the volatility in labor supply and demand led to a shift in focus from traditional indicators like the unemployment rate to other measures such as vacancy rates, quit rates, and the ratio of vacancies to unemployment, which rose to extraordinary levels. This complex labor market dynamics underscored the inadequacy of relying solely on unemployment rates to gauge economic slack, necessitating a broader analytical lens.

Central banks’ response to these challenges involved a multi-stage strategy: initially raising interest rates to a restrictive level to curb inflation and contain inflation expectations, fine-tuning the stance to ensure inflation’s return to target, and maintaining restrictive rates until confidence in inflation’s return to target was established. This approach, however, was complicated by the unexpected resilience of inflation to higher interest rates, driven in part by robust underlying demand and the uncertain, lagged effects of monetary policy on the economy.

Causes of Post-Pandemic Inflation

The post-pandemic inflation surge across various economies can be attributed to a confluence of factors, leading to significant effects and implications for monetary policy and economic recovery. The analysis, drawing on the work of Ben Bernanke and Olivier Blanchard, examines the inflation burst in eleven economies, providing insights into the causes, effects, and monetary policy responses to post-pandemic inflation. Those are the mentioned causes of inflation: