Why is inflation so high and will it stay that way? An economist explains

Inflation is rising and the prospect of a cost of living crisis looms for many people across the world. April saw a CPI (consumer price index) increase of 8.3%, while US inflation has stayed at a 40-year high.

Driven by food and energy costs in the wake of the COVID-19 pandemic, inflation has been exacerbated by the Russian invasion of Ukraine.

The monthly food price index from the UN’s Food and Agriculture Organization (FAO), which tracks prices of globally-traded food commodities, reported an increase of 12.6% between February and March to reach the highest level since its inception in 1990.

The FAO’s cereal price index rose by an even greater amount – 17.9% – over the period, reflecting a surge in global prices of wheat and coarse grains, largely due to export disruptions from Ukraine, one of the world’s largest wheat exporters.

Vladimir Putin’s invasion of Ukraine has also caused oil prices – that were already high due to pent-up consumer demand post-COVID – to soar over $110 a barrel, as many Western countries imposed crippling sanctions on Russia in retaliation.

UBS Chief Economist Paul Donovan, author of The Truth About Inflation, explains why inflation is so high and discusses whether it has yet peaked.

The current spike in inflation is described by Donovan as “historical”, but he says it won’t last at these levels for much longer.

It has been provoked by the extraordinary demand for goods in 2021 as countries emerged from lockdowns, shops opened and people were able to go out and buy stuff with money saved during weeks of economic inactivity.

“We got this extraordinary surge in demand for goods and that has pushed off inflation, because we did actually also see an extraordinary surge in supply of goods. But the demand for goods was so unusual it overwhelmed the supply and when demand is greater than supply, you either get shortages or you get price increases. What we had was a mixture of both, but some of that surge in demand pushed up prices. Now, that started to fade because, of course, by the end of last year in a number of countries, consumers’ stock of savings had disappeared so the demand was coming down.

“We’ve still got some of that inflation pressure there but it’s on its way out. If you look, for example, at television prices in the US or elsewhere, they were rising last year and are now falling, they’ve now actually got negative inflation. So we’ve started to see a correction, but there’s still enough of its lingering effects that adding to inflation.”

The demand-driven inflation was starting to fade, until the war in Ukraine wreaked economic havoc.

“There’s all sorts of humanitarian consequences (of the war), which are very tragic, but there’s also an economic consequence and that is that although Russia is not actually that significant as an economy, it’s significant in commodities.

“This has led to higher commodity prices, partly because there have been constraints on supply – either because the planting season for crops in Ukraine has been limited or because companies are less willing to purchase Russian oil, for example – but also because there’s a risk.

“It’s not just that you’re seeing prices go up because supply today is constrained. Prices are also going up over concerns the war will disrupt future supply.”

The result of this increase in commodity prices has fed through to inflation.

The price of a barrel of crude oil has consequences for things like food, airfares, petrol etc – because all of these are reliant on fuel.

“You don't pour a barrel of crude oil into the tank of your car. But we do pay for food, for petrol, airfares and so on, which are reliant on fuel. These are commodities, plus an awful lot of labour, and in the case of food, an extraordinary amount of labour.

“In a developed economy, only about 15-20% of what we spend on food is actually going on food. Most of what we spend is going on labour, which is delivering and processing, retailing and advertising. All of that comes out of what we spend on our loaf of bread; the farmer doesn't actually get that much.”

“Globally, if I look at oil prices, crude oil is just under 2.5% of a typical inflation basket. And then you've got a lot of labour turning that crude oil into gasoline. However, if the crude oil price goes up by 100%, that will add just under 2.5% percent to your headline inflation rate. And that's pretty much what's going on at the moment.”

When asked whether inflation has peaked, he says it depends where you are. “In the US, I think inflation probably peaked in March. In the UK, it’ll be a little later and in Europe, it’ll be later still. The direction of inflation in the second half of this year, I think is going to be downwards.”

He gives three reasons for that:

The best things governments can do, says Donovan, is nothing. "In as much as governments really can't change the oil price, central bankers can't suddenly change the price of wheat and other commodities."

Part of the pricing inflation story is already naturally coming down, and other factors like the impact of the Ukraine war on food and fuel prices are beyond the scope of influence from most governments, he adds.

However, it's a different question when it comes to whether government should try and mitigate the consequences of higher inflation. "There, there are things they can do. They can either look at benefits that are being paid to try and help people for higher prices, or where something is being taxed."

Oil, for example, is often taxed, so some governments may feel they could temporarily lower the tax on it, or reduce sales taxes on other products to try and make life a little bit more affordable. So there are things that governments can do to mitigate the impact in the cost of living in the short term, even if they can't change oil supply and demand.

"If we're talking over the next 10 years, then yes, of course governments can encourage investment in renewable energy and so on. But in the short term, there is a limit to what governments can do to offset price increases."