Just when it looked like the Great Inflation era was over, the world is getting a reminder of how fragile price stability can be, according to Bloomberg.
Lockdowns and supply-chain snarls from the Covid-19 pandemic sent prices soaring in 2021 and they were further propelled by a global energy crisis. This prompted central banks to undertake the most aggressive and synchronised monetary policy tightening in 40 years.
While their efforts managed to bring down inflation from multidecade highs, the momentum has now stalled and US President Donald Trump’s tariff war threatens to send prices upward once again.
What is inflation?
At the most basic level, inflation is an increase in overall prices in an economy over a period of time, usually measured on a monthly or annual basis. It’s accompanied by a decrease in purchasing power, meaning $1, for example, is able to buy fewer goods and services than it used to.
One common way to quantify inflation is the consumer price index, which tracks the change in the cost of an assortment of expenses incurred by a typical household, including food, housing and basic services.
Independent central banks consider keeping inflation in check one of their most important missions. They set interest rates and use other policy tools, such as adjusting the supply of money, to try to ensure inflation is at a ‘healthy’ level. Across many economies, including the US and European Union, the ideal inflation rate is seen as 2.0 per cent — a target first introduced by New Zealand in 1990.
How could tariffs impact inflation?
Tariffs are taxes paid by domestic companies on the goods they import, so Trump’s levies will raise costs for US businesses. While firms could swallow these extra costs and keep their prices steady, it’s more likely they’ll lift their prices to pass at least some of the financial burden on to their customers — as was seen during the trade war in Trump’s first term.
Compared to that period, the sweeping tariffs Trump has imposed this time around could be felt more broadly in the US as they capture more consumer goods such as computers and stainless steel cookware. The question is whether the price impact will be transitory or longer-lasting.
US Treasury Secretary Scott Bessent has said that there could be just a “one-time price adjustment”. A one-off price shift would still be painful for households and could become a sustained increase if inflation expectations rise, setting off a cycle of wage and price increases.
Federal Reserve Chair Jerome Powell said in mid-March that inflation “has started to move up now, we think partly in response to tariffs,” but that his base case envisages any tariff-driven bump in price growth being transitory.
Could tariffs heat up inflation globally?
Yes. If countries retaliate against American tariffs with their own levies, it could raise prices in their domestic economies as US goods become more expensive. The Organisation for Economic Co-operation and Development has boosted its projections for inflation across major economies in 2025 and 2026 versus its earlier estimates in December.
China is an outlier as it grapples with a persistent decline in prices, known as deflation, amid a protracted slump in domestic demand, coupled with overproduction. The world’s second-largest economy could serve as a counterweight to inflationary pressures elsewhere as it essentially exports lower prices globally through its cheaper goods.
Is inflation bad? Should the target be zero inflation or even deflation?
Deflation is a sign of weakness in the economy. While falling prices may sound like a good thing for consumers, it puts pressure on companies’ earnings and, in turn, workers’ wages and demand, risking a downward spiral.
Zero inflation isn’t ideal either. Economic growth will naturally be accompanied by some inflation as salaries rise and demand for goods and services increases. The key issue is the rate at which prices climb. If they outpace wage growth, the average person’s purchasing power is reduced, and households and the broader economy suffer.
Have prices been rising faster than wages?
Yes. Workers globally are still feeling the pinch from the surge in inflation seen in recent years. In around two-thirds of the 38 member countries of the OECD, real wages, which are adjusted for inflation, remain below the levels seen in early 2021 — just before the increase in prices really took off.
In the US, workers were hit hardest in the year through mid-2022, when inflation there peaked and real wages fell the most in about 25 years, according to the Federal Reserve Bank of Dallas.
What drives inflation?
Broad inflationary pressure can come from three channels: supply, demand and expectations. Disruptions to the supply of goods and services have a direct impact on their prices, such as when the pandemic limited the availability of products and some companies raised their prices.
Demand-side pressure can come when a government increases the supply of money by spending more or taxing less, or when a central bank cuts interest rates. That happened in the wake of the pandemic when policymakers flooded their economies with trillions of dollars of stimulus to support households and businesses. If demand exceeds the economy’s production capacity, inflation is the likely result.
As for expectations, the big concern among central bankers is that once inflation becomes entrenched, it becomes self-reinforcing. If business owners expect inflation to remain higher than normal, they raise prices. Facing higher prices, workers demand higher wages, which pushes companies to raise prices and fuels further inflation.
In extreme cases, this can trigger what’s known as a wage-price spiral, where higher pay and higher costs become a loop, untethered from what’s happening in the larger economy. That unfolded in the US in the 1970s and early 1980s until the Fed, led by then-Chair Paul Volcker, raised interest rates as high as 20 per cent, sparking two recessions, to finally wrestle prices lower.
How do central banks fight inflation?
Their primary tool is to increase the interest rate at which banks lend to each other — a tightening of monetary policy. The idea is that when borrowing becomes more expensive for banks, they’ll pass that cost on to companies and consumers, who will borrow and spend less, thereby cooling the economy — someone who has to pay more for their mortgage will likely cut back their expenditure elsewhere.
But adjusting interest rates is often considered a blunt tool, meaning it’s hard to use them with precision against whatever is ailing the economy. Hiking rates may douse inflation, but it also dampens overall economic growth and there’s the risk of overshooting and prompting a recession by choking off spending. Some central banks, particularly in emerging markets, are also limited in how much they can move their interest rates out of sync with what the Fed does in the US, as it would impact the value of their currencies versus the dollar.
In order to bring the post-pandemic surge in inflation under control in the US, the Fed raised interest rates to their highest level in more than two decades in 2024. This helped cool price growth from a peak of more than 9.0 per cent to around 3.0 per cent.
As inflation returned closer to the 2.0 per cent goal and risks to economic growth mounted, the Fed began to cut interest rates — as did other central banks. But the easing cycle has been patchy across the globe and price pressures remain. About a third of economies are still expected to have headline inflation above their targets by the end of 2025, according to the World Bank.
Why is inflation proving stubbornly high?
Many of the factors that drove up inflation during the world’s post-pandemic reopening are still hanging around. On the supply side, Chinese factories reopened, companies found new countries to source goods from, and energy prices normalised after the crisis sparked by Russia’s invasion of Ukraine. But there are still shortages for certain items, such as medical devices, as well as workers in industries crucial to keeping trade moving, including truck drivers. Faced with these pressures and wanting to maintain their profits, companies are still raising their prices, just at a slower pace.
Climate change and animal disease have played their part too, causing food prices to jump globally. In Japan, extreme heat decimated the country’s rice supply, while the worst-ever bird flu outbreak in the US has killed millions of hens and pushed egg prices to record highs this year.
Is there a risk of stagflation?
Stagflation is the combination of a stagnant economy and persistent inflation. It’s a rare phenomenon and one that governments want to avoid since it can be trickier to resolve than inflation or a recession alone.
During a recession, central banks can cut interest rates to spur demand or implement quantitative easing — ‘print’ money to buy government bonds, pushing up the price of those notes and lowering interest rates to encourage borrowing and spending. Conversely, during times of elevated inflation, central banks can raise interest rates and roll back quantitative easing.
But when it comes to combating stagflation, policymakers are essentially stuck — cutting interest rates could fuel further price gains, while increasing rates to address prices would weaken economic growth further.
