Đorđe Đukić, Professor Of The University Of Belgrade Faculty Of Economics

This is not a time to treat inflation using the same prescription that’s applied to typical business cycles, but rather a time of inflationary hotspots caused by a combination of factors not seen historically ~ Đorđe Đukić

When we are confronted by a major economic problem, such as the current issue of persistently high inflation, we very often reach out to economic history in the belief that it will provide us with an answer to the question of how long the torment we currently feel could last. The problem with the current inflation is that combination of causes differ from any we’ve previously seen, says Đorđe Đukić, full professor at the University of Belgrade Faculty of Economics.

What are the most important sources feeding inflation? Are they still only at the global level, or are they now also at the national level?

Pre-existing sources of inflation on the supply-side that are caused by the partial or complete breaking of supply chains for key industrial components, such as microchips, following the outbreak of the conflict in Ukraine, will persist for many years to come.

This is made worse because cost inflation resulting from rising geopolitical instability will be fed by high and unstable prices of energy inputs, metal commodities and food, as well as high costs due to a chronic shortage of highly qualified workers (talented individuals) in production sectors. These are factors at the global level, but also at national levels. So, countries that suppress inflationary hotspots on the demand side by leading a restrictive monetary policy won’t be able to do the same with cost inflation in the near future. At the national level, countries that have lost or renounced their monetary sovereignty have essentially tied their own hands, because they are unable to lead even an independent monetary policy in the battle against inflation. By maintaining a fixed exchange rate of the national currency, they create the appearance that inflation is mostly imported, thereby fleeing from accountability for a much higher increase in consumer prices compared to the same, for example, in the eurozone.

How well have U.S. and EU monetary policies been set to respond to inflationary pressures?

Following the most aggressive hike in the key interest rate since the 1980s, through the increasing of the key interest rate four times, each by 75 base points, the U.S. Federal Reserve System (FED) resorted to an interest rate increase of 50 base points in mid-December 2022. However, reducing the degree of aggressiveness in tightening monetary policy at the December 2022 meeting of the FED Board of Governors, as well as increasing the key interest rate to a level of 4.25-4.50%, the highest since 2007, doesn’t mean that the FED will stop there. And this is despite the demonstrating of more moderate inflationary pressures and somewhat more moderate annual growth of U.S. consumer prices of 7.1% in November 2022, as well as optimistic expectations among investors that inflation rate reductions will continue and inflationary expectations will stabilise in 2023, after reaching their highest level in 2022.

Economic history teaches us that, in the case that relatively high single-digit or double-digit inflation rates in relation to the target rate – mostly at a level of 2% annually – are rooted, i.e., become inert, it is necessary for monetary and fiscal authorities to implement a coordinated anti-inflationary policy over a long period, one much longer than the period during which high inflation was generated

There is major disagreement between FED Chairman Jerome Powell and key players on Wall Street regarding just how long interest rates will remain elevated in 2023. In late November 2022, Powell informed the public that the FED will continue to maintain high interest rates and the restrictive monetary policy for some time, in an effort to successfully combat and suppress inflation. He thus signalled a further interest rate hike, with no indication of when a downward turn will appear. In contrast to this, financial markets expect a gradual reduction of the key interest rate could occur as early as the end of 2023.

The annual inflation rate in the eurozone totalled 10% in November 2022, five times higher than the target rate. It stood at 11.3% in Germany. The increase of the European Central Bank’s key interest rate from 2 to 2.5% in mid-December 2022 does not provide the basis to expect inflation to slow during 2023. Why? Energy prices rose by around 35% in November compared to the same month of 2022, and rising cost inflation is unavoidable in the year ahead. Following a decline compared to the peak seen in August, gas prices are now seven times higher than they were in the 2020-2021 period, electricity prices are up tenfold and the conflict in Ukraine is certain to escalate further.

What kinds of repercussions do such policies have on economic growth and recessionary pressures that are distributed differently (higher in the EU than in the U.S., China etc.)?

There’s no doubt that the FED and ECB’s increasing of key interest rates takes a toll in the form of an unavoidable recession during 2023. That will de facto be the price for the poor evaluations of those two central banks, as well as other central banks, that the inflation experienced during 2020-2021 would be a temporary phenomenon caused by one-off expansive monetary and fiscal policy measures to maintain economic activity during the pandemic. The U.S. economy will most likely only enter a milder recession in late 2023, with declining activity appearing gradually in individual sectors, and won’t hit the entire economy at once (“rolling recession”). One indicator of the coming recession was the recently realised greatest ever difference between yields on short-term government bonds in relation to ten-year bonds since the dot-com bubble of the ‘90s.

The eurozone is most likely to enter an extended recession during 2023, accompanied by large differences between individual members in terms of intensity. According to the most optimistic scenario provided by multiple institutions, real GDP growth in the eurozone in 2023 could be slightly above zero – reaching 0.2-0.3%. In contrast, predicted real GDP growth for China in 2023 stands at 4.8%, according to a consensus among economists that was published by Bloomberg in mid-December 2022, which represents a marked upward shift from the estimated 3.2% for 2022. This comes on the back of the swift re-opening of industrial regions that were completely isolated due to the pandemic, accompanied by the halting of production. China’s rate of inflation stood at an annual level of just 1.6% in November 2022, which additionally impacts beneficially on economic growth. According to the latest calculations of the IMF, approximately a third of the world economy will record at least two consecutive quarters of declining economic activity in 2022 and 2023, with the value of lost production amounting to four trillion U.S. dollars by 2026.

New disruptions, such as a complete halting of the production of certain metals due to high energy costs (e.g., aluminium) or strikes by miners, such as those at the Chilean copper mine that’s the largest in the world, could have a chain reaction causing a new explosion in production and retail prices

What’s the outlook today when it comes to inflation returning to its previous state, and why?

Over the course of the previous five key interest rate cycles in the U.S., the period between the highest interest rate level and its first reduction averaged 11 months. So, this relates to periods when the inflation rate demonstrated a greater degree of stability, which now isn’t the case.

The optimistic expectations of financial markets are based on previous events linked to normal business cycles. Swap traders expect that, following the increase of 50 base points in the first half of 2023, the FED will opt to reduce the interest rate by 50 base points by as early as November 2023, and that this rate will total 4.5% by year’s end 2023. However, post-pandemic economic conditions differ completely compared to the past, so monetary authorities will have to maintain a high degree of caution after making short-term reductions in the inflation rate in the period ahead. New disruptions, such as a complete halting of the production of certain metals due to high energy costs (e.g., aluminium) or strikes by miners, such as those at the Chilean copper mine that’s the largest in the world, could have a chain reaction causing a new explosion in production and retail prices.

Consumers in the eurozone are signalling to the ECB that it hasn’t done enough to curb inflation. According to the latest ECB survey, expected inflation over the next 12 months has risen to 5.4%, and is set to remain at a level of 3% over the next three years. This is one piece of evidence proving that the ECB has, for many years, been facing the biggest challenge in convincing the market that it really intends to combat inflation in a credible way.

What are the consequences of enduring and relatively high inflation? If we observe the economic history of the modern age, does it appear as an aberration or a rule?

Economic history teaches us that, in the case that relatively high single-digit or doubledigit inflation rates in relation to the target rate – mostly at a level of 2% annually – are rooted, i.e., become inert, it is necessary for monetary and fiscal authorities to implement a coordinated anti-inflationary policy over a long period, one much longer than the period during which high inflation was generated. This is not a time to treat inflation using the same prescription that’s applied to typical business cycles, but rather a time of inflationary hotspots caused by a combination of factors not seen historically – continuing the massive printing of money due to the pandemic, enormous budget expenditure aimed at preventing the collapse of thousands of SMEs and helping the unemployed, lasting negative effects of supply chain disruptions for the producers of final products, huge transport costs and an unprecedented spike in energy prices, following the escalating of the conflict in Ukraine, that will not return to level seen prior to that conflict in the near future.