Should we be worried about heightened inflation?

By Andreas Charalambous and Omiros Pissarides

Inflation is generally regarded as a key macroeconomic indicator because of its negative impact on incomes, but also due to its adverse side effects on production and employment, should corrective measures need to be adopted to combat unwelcome price increases.

The inflation outlook influences vital central bank decisions on interest rates and monetary policy in general and, as a consequence, it affects public finances, investment behaviour and growth. Cyprus, as a high debt country, is particularly vulnerable.

Although inflation in advanced economies currently remains at historically low levels, the controversial discussions surrounding its future outlook have recently intensified. One school of thought supports the view that inflationary pressures will be contained due to the expected subdued growth environment, as well as structural factors which contribute to low production costs, such as globalisation and advanced technology. The other school of thought anticipates an intensification of inflationary pressures, due to the effects of the prolonged period of low interest rates and the perceived excessive provision of liquidity in the economy.

Empirically, we do observe an upward trend, in particular in the US and to a lesser extent in the EU, however all forward-looking indicators point towards a low inflation outlook.

Considering the ongoing effects of the pandemic, most central banks plan to hold interest rates at low levels for the near future and maintain an accommodative monetary policy stance through the provision of ample liquidity. Moreover, they have clearly communicated their intention to continue with this policy approach at least until the end of 2022, and to proceed thereafter with a normalisation of monetary policy but only in a gradual way and based on firm evidence that inflation is converging towards the target levels in a sustainable manner. On this subject, another important parameter concerns inflation targeting. Already, the US Federal Bank has announced its intention to tolerate higher inflation for a limited period of time compared to its long-term target level of 2 per cent.

What are the repercussions for governments and businesses in advanced economies, including Cyprus? It appears that the current environment allows for higher debt levels compared to the market conditions some years ago, provided the increased liquidity is channelled towards investments that facilitate adaptation to tomorrow’s economy and not into consumption expenditure. Under this prerequisite, governments and enterprises are in a position to extend the period of servicing their debt, taking advantage of the current benign financing conditions.

At the same time, they have to prepare a plan B for an accelerated adjustment in the event that inflation risks materialise. Undoubtedly, we live in a period of uncertainty and volatility. Flexibility, therefore, constitutes an essential element of a prudent macroeconomic policy, which can protect us from the adverse effects of an unexpected, and potentially steep, rise of inflation.

Andreas Charalambous is an economist and a former director at the Ministry of Finance. Omiros Pissarides is the Managing Director of PricewaterhouseCoopers Investment Services