By David Born and Christian Krys

The adjective "transitory" has every chance of being chosen as one of the words of 2021. At least among central bankers and analysts. While Federal Reserve Chair Jerome Powell recently revised his view that the current inflation rate of 6.8% in the US is a "transitory" phenomenon, fueling speculation about an imminent tightening of monetary policy by the Fed, the ECB has so far stuck to its assessment that the current inflation rate is a transitory phenomenon.

The scientific community of economists is divided on whether the current high inflation rates will remain high in the coming years. While both camps have good reasons for holding their respective views, in this publication we are asking what economic consequences persistently high inflation would have for companies, economies and consumers.

But first, let's take a look at the raw numbers: Inflation is currently at a record high in both the United States and Europe. Inflation has not been this high in the US since 1982, and in Europe, price inflation has never been as high as it is now since the eurozone came into existence.

The reasons for this rise are manifold: First, there is the so-called base effect, a statistical effect that results from the fact that, in order to determine the current level of inflation, the price of a certain basket of goods is compared with the corresponding price exactly 12 months earlier. But exactly one year ago, at the height of the pandemic, prices were exceptionally low. In Germany, this low price level was partly due to the reduction in VAT at the time. This base effect must therefore always be taken into account when assessing whether the current level of inflation is transitory or permanent.

A second reason for the current high level of inflation is the sharp rise in energy prices . This trend is particularly noticeable in oil prices right now. Here, too, the base situation must of course be considered: Lockdowns and the associated factory closures led to historically low oil prices in 2020. But since the beginning of 2021, the oil price trend has been going in one direction only: steeply upwards. However, it is important to put this rise in its historical context: The oil price is currently still a long way off its historic high of 2008.

Third, there is the fact that aggregate demand is currently outstripping aggregate supply. While the unexpectedly rapid recovery of the global economy last year caused demand to increase significantly, the production of supply has been unable to keep pace: This is likely due to both supply constraints and a labor shortage. EU figures demonstrate very clearly that the demand and supply trends have been diverging strikingly since the fourth quarter of the year.

The stated reasons and their exact weighting are currently the subject of heated debate: There are those who say that such high inflation is only transitory and those who fear that we will see persistently higher inflation rates in the coming years.

The majority of analysts are forecasting inflation rates of between 2.5% and 3.2% for the eurozone and between 2.0% and 4.8% for the United States in 2022. These forecasts are lower than the figures at the end of this year, but on the other hand they are higher than the average inflation rates of recent years. However, even this level of higher inflation rates would still be within the target range of the ECB and the Fed, as the two central banks target an average inflation rate of 2% and, after many years of falling short of the inflation target, could now actually exceed it.

This brings us to the crucial question: What would happen if the current inflation rates were to remain at these levels over the longer term?

A first consequence would occur very quickly and be felt immediately by all: Higher prices decrease the purchasing power of consumers , leading to less consumption, which has a negative impact on economic growth. The decrease in purchasing power also risks triggering a wage-price spiral. At the beginning of the 1970s in Germany, for example, inflation and wage growth rocketed simultaneously. This development could only be stopped with a restrictive monetary policy in the form of higher interest rates and a tightening of the money supply combined with wage restraint from the trade unions.

Second, higher prices affect not only consumers but companies too. If the prices of input factors, such as intermediate goods or indeed wages, rise, companies make lower profits. So they, in turn, will raise prices. This risks setting off a vicious circle that will have a damaging effect on growth, not just in the short term but over the long term too.

Finally, a third consequence of sustained high inflation would be that purchases and expenditures would be preponed, with consumers and companies preferring to buy their goods cheap today rather than expensive tomorrow. And such a situation leads to an ever widening gap between demand and supply. The savings rate would then fall too, which – at least in theory – should lead to higher interest rates. (Unlimited quantitative easing, as we are currently seeing, does, of course, negate this connection).

Conclusion: No one is currently in a position to say how long inflation rates in Europe and the US will remain at their current record high. However, if there is no significant reduction in inflation in the coming months, this situation would entail the dangers outlined here for the real economy – with considerable consequences for consumers and companies.