What are the main drivers of inflation?

Driver #1: Supply

Supply chain shortages and disruptions – both transitory and permanent – are a major contributor to the current inflation scenario. 

Transitory supply-based drivers originate in shocks that then have a global ripple effect. They include the COVID-19 pandemic’s impact on goods and services and the impact of Russia’s invasion of Ukraine on energy and food supply. 

Permanent supply-based drivers of inflation are structural and fundamentally transformative in nature. They include climate change, the effects of the energy transition from fossil fuels to more sustainable sources, and the shifting nature of workforce dynamics.  

Key transitory supply-based inflation drivers are the COVID-19 pandemic and the Russia-Ukraine war.

The onset of COVID-19 in 2020 brought about some of the largest reductions in global trade and output volumes since World War II. Total trade flows are now comfortably above pre-pandemic levels. Yet, trade impacts across specific goods, services, and trade partners are highly diverse, creating pressures on certain sectors and supply chains.

Ukraine is a major producer of wheat, corn, and sunflower, some of the world’s most vital crops. When the invasion by Russia virtually cut off Ukraine’s links to the global food supply, food prices soared. 

 

Similarly, Russia had been the world’s largest natural gas exporter and second-largest crude oil exporter. More than two-thirds of the 166.8% increase in natural gas in the year ending May 2022 has occurred since February 2022, while 50-60 percent of the annual price increases in crude oil and its two main subproducts (gasoline and heating oil) experienced in the market occurred during the post-invasion subperiod.¹

Permanent supply-based inflation drivers are climate change, the green energy transition, workforce changes and increased nationalism.

As heat waves, drought, and extreme flooding occur more frequently, crops yields are being slashed by climate change. This has led to decreased supply, price volatility, and export and trade restrictions. 

The green energy transition has increased demand for alternative and more sustainable energy sources. Historically, energy prices have fallen since the oil crisis of the 1970s, but have increased substantially and experienced volatility in recent years. As natural reserves of fossil fuels decrease and the demand for green energy grows, prices will remain high. 

The Great Resignation (observed by U.S. academic Anthony Klotz and first published by Bloomberg)[DR1]  is causing a workforce-level supply issue that cannot necessarily be resolved through wage increases. 

 

High-skill and low- shortages are additional contributing factors. The supply shortage of skilled AI, tech, and engineering workers will remain in place until new skilled workers enter the workforce or existing workers are upskilled. The supply shortage of low-skill workers, particularly in hospitality and services, due to the COVID crisis and related nationalism has increased salary pressures due to real-wage stagnation amid increases in costs of living.

Additional  compounding workforce issues include employment rates at maximum historic levels, aging populations looking to retire and exit the workforce, and an overall decrease in labor productivity, which has reduced the workforce supply.

Growing nationalism is also impacting food and labor supply. As demand for locally produced food and a shortage of labor pools grow, prices rise.

Driver #2: Demand

An increase in demand for goods and services – mostly transitory – is contributing to inflation. 

Unlike many or even most of the supply drivers, the demand-based drivers of inflation are largely transitory in nature. Transitory drivers tend to originate in shocks that have a global ripple effect, such as the COVID-19 global health pandemic and Russia’s invasion of Ukraine.

Bloomberg economists have identified four major transitory, demand-based drivers feeding the current inflation climate: COVID benefits spending, economic cycle acceleration, business confidence, and consumer confidence.

COVID benefits spending, and subsequent economic acceleration are fanning the flames of inflation.

COVID benefits spending refers to spending by people who benefited from government support during the COVID-19 pandemic. These consumers tended to limit spending during the pandemic but are now “catching up” with increased spending behavior in the post-pandemic era.

By November 2021, the United States government had dedicated USD $5.54 trillion (26.46% of the GDP) to COVID-19 stimulus spending.

Meanwhile, the acceleration principle posits that business cycles propagate through the economy from the consumer sector to the business sector. Put simply, spikes in consumer demand drive greater production, which then leads to workforce pressures and inflation. The current “heat” in both the domestic and global economies off the back of COVID benefits spending, however transitory, is another contributor to demand-fueled inflation. 

Fluctuating business and consumer confidence is also contributing to inflationary pressure.

When consumer confidence is high, consumption and co-related economic growth increase. Conversely, when consumer confidence decreases, spending and economic growth slow.

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Inflation can be positively or negatively impacted under either scenario, with 2022 proving to be a year of fluctuating confidence around the world.

In July, confidence in the Euro-area economy fell to its weakest point in almost 1.5 years as fears of energy shortages haunt consumers and businesses, and the European Central Bank’s first interest-rate increase in more than decade fed concerns that a recession is nearing.

In October, U.S. consumer confidence fell more than expected to a three-month low as widespread inflation and growing concerns about the economic outlook weighed on Americans.

In December, Australia’s consumer sentiment remained deeply pessimistic and business confidence turned negative for the first time all year as rapid-fire interest rate increases dragged on the economy.

In layperson’s terms, the more confident people feel about the economy and their jobs and incomes, the more likely they are to make purchases. Declining consumer confidence is a sign of slowing economic growth and may indicate that the economy is headed for trouble. So far, reduced business and consumer confidence have not managed to tame inflation mostly generated by exogenous price increases.

Driver #3: Money Supply

Money supply and its companion concepts, monetary policy and liquidity, comprise the third major driver of the world’s current inflation outlook.

Money supply is all the currency and other liquid instruments in a country’s economy. Also known as money stock, it includes both cash and deposits that can be liquidated and used almost as easily as cash.

Bloomberg economists consider four key aspects of the money supply driver:

 

The impact of changes in monetary policy on inflation (i.e., whether transitory or permanent) will depend on the capacity and credibility of a government to finance them with a balanced budget.

To finance liquidity-seeking measures such as these, governments have few and limited options, such as a debt levy that will increase inflation pressures, or taxation, which is arguably difficult to implement given the cost-of-living crisis playing out around the world. 

The impact of Russia’s invasion of Ukraine on gas prices is causing a sustained ripple effect. 

The shock on gas prices as a direct result of the conflagration represents a specific supply/demand inflationary pressure that warrants special mention because of its scale and reach.

This particular shock is also causing a sustained ripple effect on other energy prices. It is being felt particularly by Western countries that are (or were) heavily dependent on oil and gas from Russia. Such countries are faced with having to reshuffle their energy supply chain, which is a lengthy and costly process.

Though ostensibly transitory in nature, this shock has the potential for longer-term impacts if the conflict lingers on and if the countries most affected do not manage to find or finance alternative energy supplies.