Inflation is a hot topic these days, particularly in the United States where they’ve seen steep price increases in staple goods like energy, housing, and food. The Federal Reserve is under a microscope for signs that it will respond by hiking interest rates, while in the highly charged American political environment ideological battles pitting fiscal stimulus against austerity rage in the background. What makes this particularly interesting is that we know it’s not a uniquely American phenomenon, as there is clear evidence of upward price pressure in places like Europe as well.
So what’s going on? Many people will try to work that out over the years to come, but broadly speaking what I think is happening is that the global economy was forced to go into hibernation for about a year-and-a-half due to the pandemic. During that time, the U.S. government – as well as most other governments the world over – ran fiscal deficits in order to pump stimulus into their economies.
During lockdown, however, people weren’t able to spend as freely as usual. Many of them, after accounting for basic needs like food and housing, simply saved it and, as lockdown restrictions have eased, what we are seeing is all this pent-up demand being discharged back into the economy. Manufacturers and the supply chains they rely on, many of which have lain dormant for a year or more, weren’t really prepared to meet this demand once it was unleashed. And when demand exceeds supply, prices rise. So that’s what we are seeing.
A bigger question is whether this inflation is transitory or whether it will be with us for the longer-term. I think it is transitory, and the imbalances between global supply and demand will work themselves out sooner rather than later. We should also keep in mind that the United States has gone through a recent period of historically low inflation. Some inflation, particularly given the alternative of under-spending in the face of pandemic induced economic contraction, is actually probably fine and even good, although that’s not something people who are getting hit with higher gas and electricity bills will want to hear right now.
What’s more interesting to me are places that also pumped stimulus into their economies, but which have avoided subsequent inflationary pressure. And the example that jumps out at me right away is Indonesia. Indonesia was one of very few emerging economies that followed the example of the U.S. and Europe during the pandemic and had its central bank monetize a portion of its debt in order to fund fiscal stimulus. The state spent big in 2020 to counteract the worst effects of the pandemic and has continued to pump money into the economy this year as well. Yet we are not seeing anything like the inflation that the U.S. and Europe are grappling with.
I think there are a couple reasons for that. One, baseline inflation in Indonesia is typically higher than in the U.S. or other mature economies. Two or 3 percent inflation would be normal for Indonesia, but it would be somewhat unusual in the U.S. and inflation is to a large extent an expectations game. Additionally, because of Indonesia’s large informal and unbanked sector, a lot of its pandemic stimulus took the form of in-kind social assistance, such as packets of food and essential goods. This means cash transfers were not going directly to bank accounts and being saved until they were spent all at once later to supercharge the economy.
Another important thing is that Indonesia is not as tied into international supply chains, so constraints on global supply don’t show up here as strongly, especially in things like energy prices. And that is really the crux of it. Indonesia has structured its political economy so that, to a certain extent, it is insulated from big price swings determined by external forces, such as the global supply and demand of coal and crude oil.
It can do this because it has domestic energy resources and because big state-owned energy companies like Pertamina and PLN are not really meant to maximize profit. In fact, if they lose money that is probably okay as long as higher energy prices aren’t being passed through to Indonesian consumers. This makes them less efficient, less profitable and arguably uncompetitive when markets are functioning normally, but it also means when something goes haywire and there is a squeeze on global supply, the price at the Indonesian pump doesn’t move much.