For much of the decade prior to the pandemic, advanced economies appeared trapped in a cycle of low inflation or even outright deflation. Despite unprecedented interventions by central banks, inflation consistently fell short of targets, while economic growth remained sluggish. However, the COVID-19 pandemic fundamentally disrupted this trend, triggering a structural shift that propelled economies into an inflationary phase. Without the pandemic, it is very likely that the deflationary environment would still persist today, which is still the case for the Japanese economy.
The Pre-COVID Deflationary Trap
In the years before the pandemic, advanced economies faced powerful structural forces that kept inflation and growth at historically low levels:
- Persistent Low Inflation: Central banks, particularly in regions like the Eurozone and Japan, struggled to achieve their 2% inflation targets. Structural factors such as technological advancements, globalisation, and ageing populations suppressed both wage growth and consumer price inflation.
- Excess Savings and Weak Demand: Many economies experienced high levels of savings coupled with restrained consumer spending. This imbalance further dampened inflationary pressures.
- Limits of Monetary Policy: Central banks utilised extensive quantitative easing programmes and maintained ultra-low or even negative interest rates. However, these efforts failed to generate sustained inflation, highlighting the limits of monetary policy in addressing structural deflation. The reason behind that is clearly due to this expansion in the money supply (liquidity) not being passed on to the real economy.
The COVID-19 Shock: A Turning Point
The pandemic brought the global economy to an abrupt halt, but the policy response to this crisis was unprecedented. COVID-19 prompted a unique combination of fiscal and monetary measures that fundamentally changed economic dynamics:
- Massive Fiscal Stimulus: Governments across the world injected trillions into their economies through direct payments, business support, and other relief measures. This rapid infusion of money into households and businesses fuelled demand in ways that had been absent for years. This is a significant contrast in the way stimulus was introduced to the real economy when compared to the previous QE programmes observed from central banks.
- Supply Chain Disruptions: Lockdowns, labour shortages, and other pandemic-related restrictions caused widespread disruptions to global supply chains. These constraints led to shortages and cost-push inflation, driving up prices across various sectors.
- Pent-Up Demand: As restrictions eased, consumers began spending accumulated savings from lockdown periods. This surge in demand further amplified inflationary pressures.
- Labour Market Shifts: The pandemic reshaped labour markets, with many workers leaving the workforce or demanding higher wages. This trend added to rising costs and, in turn, inflation.
A Structural Shift Away from Deflation
Beyond the immediate economic impacts of COVID-19, the pandemic accelerated longer-term changes that are likely to sustain higher inflationary pressures:
- De-Globalisation: Companies began reshoring and diversifying supply chains to reduce reliance on overseas production. While necessary for resilience, these changes have increased costs compared to the pre-pandemic era of hyper-globalised, low-cost production.
- Wage Growth and Labour Power: Labour shortages and shifting worker preferences have bolstered wage growth, creating a feedback loop for rising costs and prices.
- Central Bank Policy Reversals: The extraordinary fiscal and monetary measures enacted during the pandemic created inflationary pressures that central banks were forced to counteract. As a result, we have seen aggressive interest rate hikes not experienced in decades.
What if COVID-19 Hadn’t Happened?
Without the pandemic, it is plausible that economies would have remained stuck in a deflationary environment:
- Monetary Policy Stagnation: Central banks had already exhausted many of their tools. With interest rates at or near zero, there was little scope for further monetary easing.
- Structural Deflationary Drivers: Factors such as demographics, technology, and globalisation were firmly entrenched as deflationary forces, keeping prices and wages subdued.
- Political Barriers to Fiscal Stimulus: Prior to COVID-19, large-scale fiscal interventions were politically unpalatable in many countries. The pandemic created the urgency and consensus necessary to overcome this resistance.
How Important COVID-19 really for the Global Economy
COVID-19 served as the catalyst that jolted the global economy out of its deflationary fate. Through a combination of fiscal stimulus, supply chain disruptions, and shifts in labour markets, the pandemic created inflationary pressures that policymakers had long struggled to achieve. Without it, the structural deflationary forces of globalisation, ageing populations, and technological advancement would likely still dominate the economic landscape. While inflation presents new challenges, it has also marked the end of a prolonged period of stagnation, paving the way for a new economic chapter.
– Caio Marchesani