Opinion – Samuel Pessôa: Covid inflation

After years in which the northern hemisphere had to deal with disinflationary pressure, with the risk of deflation and nominal interest rates close to the lower limit of zero, Covid brought inflation back.

We have already had the opportunity to discuss the nature of inflation in the column. In addition to the shocks to agricultural commodities, produced at the end of 2019 by the African swine flu, which slaughtered 40% of the Chinese herd, and, more recently, by the War in Ukraine, there was, at the turn of 2020 to 2021, a strong disorganization of global value chains . The price of industrial goods exploded.

The very long period of social distancing, with very intense use of domestic space, increased the demand for durable consumer goods and industrial goods in general. It was necessary to adapt the domestic environment to the new uses that came to be made of it.

There are two notable features of these shocks. First, the pandemic was not anticipated. The pandemic shock was exogenous to the dynamics of the various economies. Second, in the previous period there was a relative convergence of inflation among the countries of the northern hemisphere.

Despite the previous convergence and the shock being shared, inflation has not risen in the same way in all countries. We also know that the fiscal response was not the same.

Question: is there an association between the fiscal response and the inflationary surge? Are the countries that earmarked larger budgets for people’s income support the ones where inflation is higher today?

We are facing a rare situation in macroeconomics. The biggest difficulty is that all the variables are changing simultaneously. It is very difficult to characterize causality. We are always in the midst of a dynamic process, in which it is very difficult to establish a beginning. That is, to establish a moment and a fact that are disconnected from a previous dynamic.

Recent work by Òscar Jordà and Fernanda Nechio, researchers at the San Francisco unit of the US Central Bank, identified the impact of income support policies on inflation. The identification strategy was exactly the one described in the previous paragraph.

The authors considered Canada, USA and 15 European countries. For each economy, they constructed the variable “personal income deviation”. This is the difference between actual personal real income, which includes the benefits of emergency income transfer programs due to the pandemic, and real personal income if the epidemic had not occurred. The latter is given by simply extrapolating the trend that prevailed before the crisis. Evidently, this variable has very different dynamics between countries.

The work has two important results. First, “a 5 percentage point increase in real disposable income over trend translates into about 2.5 percentage points of additional inflation after four quarters. We find the effect on wages to be of similar magnitude.”
This effect will vary depending on the distribution over time of the aid package. More spread out over time will generate less inflation.

The second result of the work is the importance of inflationary expectations in determining wage increases. Even if, before the epidemic, given the highly disinflationary environment, expectations were not very important, the change to a higher inflation regime increased the weight of inflationary expectations in the determination of nominal wages.

The work rejects the view that there is great elasticity of supply to demand shocks. Scarcity reigns. Long live political economy. It is necessary to know who pays the bill and who benefits from the State.