Nordea On Your Mind: The return of inflation

“Hello inflation, my old friend.”

Those are the opening words for the latest Nordea On Your Mind Report: The return of inflation, and the musical reference couldn’t be more fitting. Inflation is top of mind for many these days, and the Nordea Thematics duo Johan Trocmé and Viktor Sonebäck take a deep dive into the hot topic with analysis, illustrations, historical data and interviews with Nordic experts. 

Back from the dead

For most of the past decade, in the majority of advanced economies, inflation has either been a non-issue or so low that it has become a problem, in that central banks have undershot their inflation targets. This has led to a prolonged period of ever-more extreme efforts by central banks, including negative policy interest rates and quantitative easing (bond purchases), to raise ultra-low inflation. After years of building up imbalances, with low interest rates creating asset price bubbles, and central bank balance sheets swollen with bonds, an energy and food price shock coupled with trade disruptions has suddenly reversed the inflation trend into a swift and sharp spike. In the midst of this environment, we believe it is helpful to offer a review of what inflation is, how it works, what drives it and how it could be controlled.

What is it, and why don't we like it?

Inflation can be defined as an increase in the general price level for goods and services in an economy. Policymakers measure it with a consumer price index (CPI), based on a basket of goods and services for a typical consumer. CPIs are not identical, but very similar among advanced economies. When pursuing inflation targets, central banks tend to focus on core inflation indices, which exclude potentially volatile energy and food components. Inflation as such is not harmful, and is indeed inherent to the economy. Nevertheless, high, volatile or unpredictable inflation can hurt the economy, particularly by making economic planning very difficult for both businesses and households.

Where does it come from?

In macroeconomics, the Keynesian school of thought argues that inflation results from imbalances between supply and demand in the economy, while the monetarist view is that it is all about the money supply. The latter is almost universally the theoretical basis for the monetary policy of the central banks in advanced economies today. The two oil shocks of the 1970s drove more severe inflation spikes than what we have seen so far in 2022-23. Back then, soaring oil prices drove up inflation broadly, with general cost inflation leading to a wage-price spiral, and inflation remained high until the early 1980s. The current inflation spike is driven more directly by high energy and food prices.

How do we control it?

The traditional tool for controlling inflation is policy interest rates. Since the global financial crisis of 2008, central banks have also turned to more extraordinary tools, such as negative interest rates and quantitative easing (buying bonds to push down long-term interest rates), which they now wish to phase out. The current consensus view is that this temporary inflation spike should abate by 2024. We highlight some factors that could potentially add to inflationary challenges, and encourage corporates to consider some 'what ifs' when deciding what leverage and interest rate exposure they can live with in the coming years.

Insights from experts and policymakers

Norway's central bank has been more pragmatic than dogmatic in managing inflation, and has not resorted to negative interest rates or quantitative easing. We asked Norges Bank Director of Monetary Policy Ole Christian Bech-Moen about the thinking behind their approach. 

“Monetary policy target is set by political authorities, and we have a clear and sound mandate for monetary policy in Norway. Especially in periods of structural change and considerable uncertainty, it is even more important that monetary policy contributes to price stability and stability in the economy, ” Bech-Moen says in the interview. 

We naturally turned to Nordea's Torbjörn Isaksson, Chief Analyst in Macro Research and our resident inflation guru, for a crash course on how inflation works.

“Inflation is a natural, inherent part of an economy, and it is a widely accepted view that a certain level of inflation is normal and desirable. A high inflation rate is usually also volatile. This combination of rising and unpredictable prices makes economic planning difficult for households and companies,” Isaksson says in the latest NOYM report. 

And, to better understand how inflation is quantified and measured, we interviewed John Eliasson from Statistics Sweden.

“Statistics Sweden is tasked by the Swedish Parliament to produce a consumer price index every month. There are time series going back to the 19th century, but in its current form the index data goes back to the 1950s. The main measure is the CPI, which is a cost-of-living index,” Eliasson says.