Posted: 27 May 2022 8 min. Lukuaika

The return of inflation

As the global economy started to emerge from the covid-19 pandemic, strong economic growth was back - and so was inflation. The rate of inflation had stayed slow for several years but according to ECB1 the growth of inflation coming to 2022 has been the fastest in 13 years. The sharp increase in inflation blindsided many economists, almost no one saw it coming. Just as we were starting to leave the pandemic behind in Europe, the convergence of Russia’s invasion of Ukraine and new COVID-19 lockdowns in China are adding to business and consumer concerns that inflation rate will remain high well into 2022.

But is this inflation just a temporary blip or could it spiral out of control? This blog post gives you a look at the underlying mechanisms behind this recent surge in inflation, implications for both consumers and producers and actions that can improve performance under inflationary uncertainty.

Inflation during the covid-19 pandemic – what happened

Economists distinguish between two types of inflation: Demand-Pull Inflation and Cost-Push Inflation.

figure 1: Demand-Pull & Cost-Push -inflation, by author

The Covid-19 pandemic has been an unprecedented combination of supply and demand side shocks. These shocks spread through supply chains causing different sectors to become demand-constrained or supply-constrained.  Both fiscal and monetary authorities responded to the pandemic with massive measures. Large stimulus packages combined with accommodative monetary policies prevented mass layoffs and bankruptcies as well as prevented liquidity shortages. At the same time the arrival of vaccines allowed economies to gradually lift lockdown measures supporting the renewal of economic activity and unlocking consumer savings in an unprecedent pace.

After lifting the first covid restrictions, economic activity around the globe increased. During the pandemic, consumers increased their savings rate opting out of consuming but now consumers are once again increasing their rate of consumption. The economies and consumer demand are growing, and companies can increase their prices without fear of losing customers. The growth has however been uneven. 

Many companies struggle to meet the growing demand due to dwindling stocks. The global supply chain faces problems with a shortage of containers, increasing the cost of transport. This leads to companies having to incorporate these increasing cost factors into their pricing.

The increase in consumer demand, especially in electronics, has caught the suppliers by surprise. The pandemic has shown that many companies are not fully aware of the vulnerability of their supply chain relationships to global shocks. Offshore produced components such as semiconductors are in short supply. When there is a shortage of components and increasing demand for products using these components this will eventually lead to an increase in prices.

Consumer goods aren't the only factor in growth of inflation. According to ECB1 nearly half of recent growth of inflation can be accounted for by the rising cost of energy. The price of oil, gas and electricity has risen all around the world due to decrease in production combined with increase in demand. Since the increase in the price of energy has a multiplier effect on other costs, the increase in the price of energy has a major impact on the rate of inflation. Adding to this, Russia's invasion of Ukraine and the sanctions that followed have meant spiraling energy costs across the EU. In Europe, already elevated inflation rates may now be driven even higher, given the conflict-induced oil and gas price shock.

After the start of the pandemic, the manufacturers started to cut back on production because they expected the incomes and spending would fall in a way that they typically do in a recession. Instead, the opposite happened. Income surged due to the generous fiscal support and spending on goods picked up because households had money to spend but the normal consumer services that they would spend on were largely unavailable such as tourism or other leisure services.

Good news about this surge was that it enabled quick recovery for the manufacturing business. The bad news was that many businesses weren't expecting this, they necessarily hadn't ordered enough input and parts to meet the rising demand and getting imports proved to be difficult during a global pandemic. 

The combination of high demand and limited supply for international shipping led to a shortage of containers and port congestion problems. This in turn leads to lengthy shipping delays.

Inflation caused by supply chain disruptions is fundamentally different than the demand induced inflation typically managed with macroeconomic fiscal or monetary policy. With supply chain disruptions, the capability of the economic system to provide goods and services is impaired. Repairing the supply chain is expensive, time-consuming and may involve many years of elevated prices. Building more shipping containers, expanding the capacity of ports - it all takes considerable investments and time.

What can we expect going forward?

According to Ira Kalish2, the chief global economist for Deloitte, in year 2022 the inflation will either peak or is close to peaking. On the point of temporary or long-term inflation Kalish sees that this is more likely to be a temporary phenom, reason being that the major factor contributing to the higher inflation was the supply-chain disruption in the market for goods. That's reflected in the fact that it's the prices of goods rather than services that have increased so much. Kalish's expectation is that, over the next year or year and a half, we'll see this supply-chain disruption recede, because consumer demand for goods will recede. It's already starting to happen. 

Manufacturers and transport companies will improve the efficiency of their supply chains. There are of course factors of uncertainty that could affect this estimate. One thing is that if the virus situation is prolonged especially in China, it will prolong the supply-chain disruptions. Another possibility is that as inflation persists, people's expectations of inflation change in ways that change their behavior. So, if workers expect very high inflation, they will seek higher wages, and businesses will provide those higher wages. And that, in turn, itself will be inflationary. Finally, Russia's invasion of Ukraine will continue to affect especially energy prices in Europe, casting a shadow of uncertainty for the price levels in Europe.

What should businesses do now

Attentive business leaders should be thinking about what the business impacts of heightened inflation might look like. To help in their considerations, Deloitte developed four critical uncertainties3 that are likely to impact the future of inflation:

  1. How long will supply chain disruptions last?
  2. How do inflation expectations affect wage negotiations?
  3. How do consumer spending habits evolve?
  4. What is the nature of monetary policy?

The challenge for business leaders will be to manage this uncertainty in a way that allows their businesses to thrive. Several strategies will be useful regardless of how inflation evolves. Creating ways to lower costs and reduce disruptions to operations are almost always good ideas. Deloitte global economists3 have identified the following actions that can improve performance under any of the four scenarios.

  • Shore up capital structure. Rebalance portfolios and lock in today’s cost of capital in anticipation of interest rate variability.
  • Proactively address supply chain disruption. Focus on building a diversified supply chain with enough slack to ride out uncertainty.
  • Build for continuity. Invest in systems that enable smooth operations in periods of high labor turnover (e.g., training capabilities, automation).
  • Consider smart hedges. Make strategic decisions about where to hedge (e.g., pre-buying raw materials) and consider areas most susceptible to destabilization.
  • Build a strategic market-sensing function. Develop internal capabilities to monitor how the future could unfold to trigger deployment of contingent strategies and hedges.

As 2022 continues, inflation is top of mind for business leaders, political leaders, central bankers, investors, and ordinary consumers. This was not true just a year ago. Things have changed very quickly. The question now is whether they will change quickly yet again.

Monitor Deloitte

Our mission at Monitor Deloitte is to help our clients to navigate the future with confidence. Organizations need to make and act upon the right choices: clear, timely and inspirational choices that deliver growth in a dynamic, disrupted world. We are the strategy consulting practice of Deloitte Consulting and help our clients to address a variety of management areas, including organic growth, corporate & business strategy, business design & configuration, ventures, strategic transformation, strategic sensing and insight.

Ota yhteyttä!

Joonatan Laakso

Joonatan Laakso

Monitor Deloitte

Joonatan is an experienced management consultant, and he leads strategy and business design consulting in Finland, at Monitor Deloitte. He focuses on advising clients in business and growth strategies, client experiences, pricing, and digital. In addition, he has strong background from business transformation consulting.

Henrik Kekarainen

Henrik Kekarainen

Analyst I Monitor Deloitte

Henrik Kekarainen toimii strategiakonsulttina Monitor Deloittella yritys- ja kasvustrategioiden parissa. Hänellä on kokemusta useiden eri alojen asiakkaiden kanssa työskentelystä aina terveydenhuollosta ja kuluttajatuotteista valmistavaan talouteen ja julkiseen sektoriin. Henrik on kokenut tekijä yritys- ja markkinakohtaisien taloudellisten analyysien sekä datan ja analytiikan saralla. Koulutukseltaan hän on taloustieteilijä ja on aiemmin toiminut tutkimuksen parissa taloudellisessa tutkimuslaitoksessa. Henrik Kekarainen works as a strategy consultant at Monitor Deloitte on business and growth strategies. He has experience working with clients in a variety of industries ranging from healthcare and consumer products to the manufacturing economy and the public sector. Henrik is experienced in the field of company- and market-specific economic analysis as well as data and analytics. He is an economist and has previously worked in research at an economic research institute.