COVID Inflation, What Is Causing It and What Should We Expect In the Long Run

The COVID-19 pandemic has turned inflation on its head, where central banks before were at or below the zero-lower bound, today we see the world’s central banks raising rates for the first time in years. This raises two questions, is our current inflation a long-term phenomenon or “transitory” as was claimed by the Fed and if it is long-term, have the dynamics of inflation changed?

In discussing the dynamics of inflation, I mean to refer to the determinants of the rate of inflation, for which the story of economics provides several theories.

In my opinion, inflation during COVID is transitory, but I do not mean the word in the same sense that the Federal Reserve had. The Fed’s meaning was that current short-term market forces were causing inflation, a view which very much skirted any onus in causing the current rate of inflation.

Any economist who believes in the quantity theory of money (QTM) would have predicted the large inflation we are currently experiencing.

For those who do not know what the QTM is, at its most basic, the theory states that the economy's general price level is proportional to the quantity of money. COVID saw central banks massively increase the quantity of money, with the Fed’s balance sheet doubling from March 2020 to May 2022 and the RBA tripling its balance sheet between March 2020 and June 2021.

I do not mean to blame central banks across the globe for their monetary expansions, one could not fault them for facilitating government programs that were aimed at reducing financial distress. However, the current state of inflation is not one that should puzzle economists, the quantity of money was rapidly expanded, the quantity of goods shrunk due to supply-side issues and the lynch-pin, the velocity of money increased, meaning the speed at which money changed hands increased.

​In some ways, this holds parallels to the 70s and the oil crisis. Monetarists such as Milton Friedman argued for the need of stable growth of the money supply, that where there was a rapid increase in the quantity of money, you would see a rise in inflation. Such economists denied the claims made by others in the profession who ascribed the inflation to cost-push inflation, increases in the cost of production goods.

Chairmen of the Federal Reserve have stated Friedman was right in his analysis of the Great Depression, but does that make the QTM a viable theory for explaining the 70s or predicting the inflation movements of this decade.

If inflation is transitory in the sense I have defined it, caused by and responsive to changes in the quantity of money, then the actions of the central banks currently are logical.

Transitory inflation indeed would reflect well on the QTM and in my estimation demonstrate that the underlying dynamics of inflation have not changed. That inflation is still “everywhere and always a monetary phenomenon”. If it is not transitory but the reflection of market conditions unrelated to monetary policy, then it is likely a recession may be deepened without necessity.

One of course could rebut that the primary reason we are seeing inflation is the supply shocks the economy has been experiencing for nearly three years now, irrespective of the money supply.

If firms and producers expect that it will be difficult to supply goods for the expected demand at current prices, then they will naturally raise prices as a rationing tool. Indeed, there are several factors which are driving pessimistic long run supply expectations, interest rate hikes, the invasion of Ukraine and tensions between the US and China.

These events reflect current and long term shifts in the global economy, which we can predict have an effect but the depth and longevity of their effects remain elusive. As we see continuous destabilising shocks to supply chains, prices will continue to rise if demand remains stable or outstrips supply and the supply either becomes scarce or threatens to do so.

In the most fundamental sense, could this not be a driver of the inflation we are experiencing? As we all know from our microeconomics courses when supply and demand are both inelastic, we should expect to see prices rise as a reflection of the behaviour of consumers and suppliers.

If inflation can not be tamped down by rising interest rates but continues to rise in spite of tighter monetary policy which theoretically should slow down monetary velocity, serious questions must be asked as to how capable central banks will be at managing this episode of inflation.