Will inflation soon go back to 2 percent, and is that really necessary?

Just get her back in her cage, that inflation. In April it amounted to 5.2 percent, which was higher than inflation in March, which was 4.4 percent. It is difficult to predict what inflation will be in May – the figure is too volatile for that at the moment. But given that ‘core inflation’ without energy prices, according to Statistics Netherlands, was still 7.8 percent in April, a too rapid decline should not be expected.

Are we stuck with high inflation? Not that. The economy is cooling rapidly, and lower demand for goods, services and investments should do its job. But time is running out for policymakers.

The public accepts exceptional circumstances (Covid, war) that cause inflation for a while, but at some point it runs out of patience. On Wednesday this week, there was a hearing on inflation in the House of Representatives, which was actually about the question of blame: is it rising wages that are now keeping inflation going, or is it ‘grabbing inflation’ – excessive price increases by the business community?

Western consumers, ie citizens, ie voters, are not accustomed to inflation. Inflation has been so low in recent decades that the public essentially assumes price stability – in other words, the absence of inflation. So calculating with inflation in everyday life is kind of new. How unfamiliar this is, is shown by the fact that Statistics Netherlands now explicitly warns when it publishes inflation figures that the inflation rate of 5.2 percent in April does not mean that prices are now 5.2 percent higher than the month before, March, and so all the inflation numbers are accumulating on a monthly basis. Apparently some of the public had that idea. The inflation rate of 5.2 percent means that prices are 5.2 percent higher than a year ago.

Another common misconception is that declining inflation means that prices themselves will also fall. That is not true. Inflation pushes up the level of prices. And if inflation falls, prices will still rise, but at a slower rate. For clarity:

Whoever has a problem with that is not stupid, but ignorant. Very understandable: inflation had disappeared from the collective brain and must be given a place there again. Compare it with summer and winter time. If the clocks were moved forward or back an hour every week, everyone would soon be able to deal with this intuitively. But because it happens once every six months, people (including those who consider themselves smart) have to think again and again: will I have an hour more or less tomorrow?

Many of the initial drivers of the high inflation are now on the retreat. The shock that took place when the Western economy opened up in one fell swoop in the summer of 2021 and disrupted all trade and production chains is over. Overseas transport prices have fallen sharply. And the US central bank’s supply-chain indicator, which indicates the extent of the stress in global production chains – which led to scarcity and therefore higher prices – is now at ‘no problem’. The same applies to energy prices. But for food, the prices of which hardly fall, if at all, that applies even less – one of the reasons why inflation does not fall quickly.

Three of these four reasons that many companies gave for raising their own prices are therefore no longer valid. Complaining is therefore allowed, and it is done. Especially against supermarkets, where the high prices are visible. The latter is understandable, but not always fair. Such as delayed train passengers expressing their displeasure to the conductor. He can do little about it, but is the only one who is approachable. But the real ‘mark ups’, price increases above the increased cost of production, take place in the more abstract chains that precede the shelf in the store. For example, at the industrial conglomerates where the food is made.

So the public is getting fed up with inflation. But should central banks, which are cooling down the economy with interest rate hikes – and perhaps even bring them into recession – really bring inflation back to the 2 percent they have been aiming for for years? Shouldn’t they end up a little higher, at 3 percent or 4 percent?

There has been a debate about this for some time, which was started ten years ago by one of today’s most prominent economists: Olivier Blanchard. His point at the time was that inflation, at a target of 2 percent, could quickly, and undesirably, drop below zero. Then central banks have to pursue the strange policy that they actually did then: interest rates have to fall with it, but with that fall below zero (and become negative) or large quantities of government bonds have to be bought up to bring interest rates towards zero (or below). With an inflation target of, say, 4 percent, you don’t get into that danger zone that quickly.

Blanchard cited a very nice study in November last year, which allegedly shows that in many countries the public only reacts when inflation is between 3 and 4 percent – ​​except for the Germans, by the way, who still think 2 percent is high.

Still, you have to be careful with such a higher inflation target. As said, the Western public does not actually assume that there is inflation at all with a target of a maximum of 2 percent. And will, presumably, not adapt to this with behavior or demands (for example, wages) that will subsequently drive up inflation. Such price stability is a great asset. That’s what we’re learning right now.