Central bank asset buying real inflation culprit

The central bank officials in highly developed economies have successfully merited their summer break. By implementing a sequence of significant increases in interest rates, they seem to have successfully repelled a surge in inflation that, according to popular belief, was triggered by an unparalleled combination of adverse events. However, before we commend the central bankers for controlling inflation, we must take into account their contribution to its occurrence.

The primary reason often mentioned for the recent increase in inflation is the elevated cost of energy. This occurred as a result of Russia's complete invasion of Ukraine, causing concerns that sanctions imposed by Western countries would impede the distribution of Russian hydrocarbons. However, by early 2023, the prices of crude oil had returned to the levels observed before the invasion took place.

Additionally, it is crucial to note that the sharp increase in oil prices in 2022 was not uncommon. Similar rapid price hikes and peak levels were observed in previous years, like in 2008 and 2011-2012. However, none of these instances led to a significant rise in overall price levels. Even in Europe, where the surge in natural gas prices following the invasion was unparalleled, energy prices reverted back to pre-war levels long before inflation started to decline.

Not a single central banker has acknowledged the valid uncertainty that the sudden rise in non-energy prices last year could be attributed to the energy price shock. Instead, central bankers have shifted the blame to another factor: disruptions in the supply chain.

However, the surprise mentioned above was fleeting as well. The global supply-chain pressures composite indicator from the Federal Reserve Bank of New York reveals an unparalleled rise in 2022, yet it returned to its typical range by the beginning of 2023. At present, it stands at a negative level, signifying that supply chains are operating exceptionally well.

The majority of macroeconomic models, and even basic logic, suggest that a short-term disruption in supply should lead to a corresponding short-term rise in prices. If the recent increase in inflation was truly the result of the two supply shocks in 2022, then initially it would have exceeded the standard 2% target, but eventually decreased below it as the shocks diminished. However, this is not happening in the United States or the eurozone. If we exclude the influence of declining energy prices, inflation remains persistently high at around 4% to 5%.

One might possibly claim that imbalances could potentially lead to variations in overall prices during times of increasing and decreasing energy costs. However, it is not evident what specific imbalances would be relevant in this specific situation. Despite a shortage of available workers, they have agreed to a decrease in their actual wages. Additionally, even though it might be necessary for certain prices to decrease alongside energy prices, there is no indication that the inflexibility of nominal prices or wages is currently influencing the scenario.

So, why has the continuous rise in prices happened? One possible explanation is that we are witnessing the prolonged consequences of previous actions taken to manage the flow of money. During the years of 2020 and 2021, when the world was experiencing the destructive impact of the pandemic on the economy, central banks started acquiring massive quantities of assets. In the initial months of 2020, this approach had a specific objective - to stabilize the financial markets. However, even after achieving this objective, central banks persisted in purchasing assets.

At this juncture, financial authorities were driven by apprehension of deflation. However, even though the rate of inflation diminished during the years 2020-21, this was primarily attributable to a momentary decline in energy costs. In essence, the policymakers' choice to persist with significant acquisitions of assets was an exaggerated response to a transitory disruption.

It should come as no surprise that this policy resulted in inflationary effects, and it took some time for them to become apparent. As Milton Friedman explained, the impact of monetary policy on the economy takes a long time and varies. Assuming a delay of 12 to 24 months, the central banks' asset purchases during the pandemic would have started influencing inflation by the end of 2021, with the strongest effects occurring in 2022-23, when the job market was tight. The condition of the job market would explain why pandemic monetary policy had a greater impact on core inflation compared to the previous unconventional monetary policy in 2015-18.

Determining the exact extent of responsibility that pandemic asset purchases bear for the present inflation is challenging. However, if we consider the European Central Bank's evaluation of its policy between 2015 and 2018, it could be inferred that these purchases played a role in causing a slight increase in inflation, amounting to a couple of percentage points. Therefore, had the US Federal Reserve and the ECB ceased their asset purchases after stabilizing the financial markets in early 2020, the current core inflation could have stood at approximately 3%, as opposed to 5%.

Certainly, the substantial financial aid measures implemented during the pandemic likely had a part in causing inflation, particularly in the United States. However, this does not absolve monetary policymakers from responsibility. In fact, despite their desire to emphasize their success in curbing inflation, central bankers in America and Europe cannot deny their substantial involvement in the issue's creation.

Daniel Gros holds the position of director at Bocconi University's Institute for European Policy-Making.