Greater geopolitical instability and a more extreme climate threaten to lead to more supply shocks in future, increasing the chances of global inflation spiking up.
Global supply chains often get disrupted because of geopolitical instability such as conflicts or trade disputes. Similarly, extreme weather events like hurricanes, droughts, or floods disrupt agricultural production and logistics.
These disruptions generally lead to shortages of goods, driving up prices due to increased demand relative to supply.
Instability in key regions result in increased costs of production due to factors such as higher transportation costs, tariffs, or sanctions. Similarly, extreme weather events damage infrastructure or agricultural lands, leading to increased production costs.
These increased costs are often passed on to consumers in the form of higher prices for goods and services.
“Over the longer-term, we expect inflation to average around 2%, though this will include longer periods above target than was the norm post-financial crisis,” according to Oxford Economics.
After a period of exceptionally low and stable inflation in the 2000s and 2010s, several factors –especially greater geopolitical instability and a more extreme climate – could lead to more supply shocks in the future. This increases the chances of inflation spiking up.
“Whether inflation will be generally higher or just more volatile will depend on the economic backdrop and how central banks respond. We expect higher policy rates on average, partly because domestic demand is unlikely to be as persistently weak as in the 2010s, so a repeat of the last decade’s private sector deleveraging and fiscal austerity seems unlikely,” Oxford Economics noted.
At the same time, the chances that strong demand will pose a risk of persistently high inflation seem overblown. More spending on defence, the greening of the economy, and ageing doesn’t automatically mean bigger budget deficits.
But if they do rise, then policy rates would likely be higher to offset the effect.
Although deglobalisation could add to inflationary pressures, analysts see this as a risk rather than an inevitability. Meanwhile, despite the recent strength of inflation, real wage rises have generally lagged productivity growth since 2019.
Another factor that could add to inflation overshoots is how firms respond to demand and supply shocks. It is possible they are now more inclined to raise prices.
But the post-Covid lockdown resilience of demand to price hikes may have reflected exceptional factors that won’t be repeated. Meanwhile, an AI-driven productivity boom, if it happens, would likely dampen inflation, Oxford Economics says.
Despite the severe post-pandemic inflation overshoot, advanced economy central banks belatedly showed a resolute commitment to keeping longer-term inflation expectations anchored. Aggressive hikes proved that central banks were prepared to risk recession to bring inflation back to target.
As a result of this and subsiding headline inflation, long-term inflation expectations have quickly fallen back.
Although greater geopolitical instability and extreme climate events invariably contribute to inflationary pressures, the actual impact will depend on a range of interconnected factors, including the severity and duration of disruptions, policy responses, and broader economic conditions.
That said, longer periods of above-target global inflation may lead to more policy tightening in future.