Supply & Inflation

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Inflation is rising fast, and central banks are under pressure to take drastic action. But their only real option is to reduce demand, by raising interest rates and withdrawing liquidity. These measures have already spurred a massive repricing of assets, including currencies, and they threaten to push global growth below potential, with lower-income economies suffering disproportionately, and to reduce investment in the energy transition.
There is another way; supply-side measures. Trade and investment have long enabled supply to expand rapidly in response to growing gtlobal demand. But, for nearly two decades – and especially in the last few years – proliferating trade barriers have been adding friction to this process. Creeping protectionism must be reversed, with US President Joe Biden removing the tariffs imposed by his predecessor, Donald Trump, and Europe accelerating the integration of its services markets.
At the same time, efforts must be made to improve productivity. Digital technologies will be crucial here. While the pandemic helped to accelerate the digital transformation, many sectors – including the public sector – are lagging, and concerns about the effects of automation on employment persist. But in a supply-constrained world characterised by persistent labour shortages, productivity-boosting digital technologies, together with higher wages for workers, would go a long way toward improving the balance between supply and demand.
For example, artificial-intelligence-based tools can perform a wide range of functions, from screening luggage more efficiently at airports to analysing medical imaging to detect cancers. Beyond digital technologies, regulatory regimes can be streamlined and improved, in order to reduce supply-side bottlenecks. Such an agenda must be applied to both the public and private sectors. At the international level, efforts to facilitate trade, address supply-chain rigidities, and close data gaps will be essential. Otherwise, central banks will be left to deal with inflation alone – with dire consequences for the entire global economy. Central banks’ efforts to contain high and rising inflation are fuelling growth headwinds and threatening to tip the global economy into recession. But the proximate cause of today’s inflationary pressures is a large, broad-based, and persistent imbalance between supply and demand. Higher interest rates will dampen demand, but supply-side measures must also play a large role in inflation-taming strategies.
Over the past year or so, the rollback of pandemic-containment policies has spurred a simultaneous surge in demand and contraction in supply. While this was to be expected, supply has proved surprisingly inelastic. In labour markets, for example, shortages have become the norm, leading to cancelled flights, disrupted supply chains, restaurant closures, and challenges to healthcare delivery.
These shortages appear to be at least partly the result of a pandemic-driven shift in preferences. Many types of workers are seeking greater flexibility – including hybrid or work-from-home options – or otherwise improved working conditions. Healthcare workers, in particular, report feeling burned out by their jobs. If this is true, the inflation picture must include an adjustment in relative labour costs. To bring markets back into balance, wage and income increases will be needed, even for jobs for which there was previously an ample supply of workers.
This transition will generate some inflationary pressure. Yes, nominal prices and wages have limited downward flexibility. But at a time of excess demand, firms generally try to pass on higher costs via price increases – and they often get away with it, at least for a while.