Explaining the Pain

The global economy, still reeling from the U.S. financial crisis, has entered an even riskier phase on account of inflationary pressures. Inflation is particularly painful when it is driven, as it is now, by price increases on essential products like food and fuel. Governments and companies have to react even if they end up using blunt instruments that initially make the situation worse.

Today's situation is particularly complex, as a good part of the recent price rises were driven by these perverse second-round effects. This is evident on both the supply and the demand side where the immediate reactions of many market players to the food and oil price rises aggravated global supply-and-demand imbalances.

For example, rather than increase output in response to higher prices, some food producers imposed export bans in an attempt to safeguard supplies for their domestic populations. In the process, they cut supply to a fragile world market in which prices were already rising. In the energy market, some companies (including airlines) rushed to secure supplies by purchasing future contracts that, ironically, they deemed too expensive to buy at lower prices. That too fosters price increases.

This perverse dynamic is starting to reverse itself. Additional supply is beginning to hit the food and energy markets as other producers seek to capitalize on the significant price jumps. Also, part of the demand for these products is being destroyed as a growing number of consumers get priced out of markets.

But this reversal is not happening fast enough, especially when it comes to sheltering the segments hardest hit by inflation, such as the poor. This raises the pressure on policymakers to do something, if only to show that they care.

Certainly prompt policy action is needed, to moderate expectations of future price increases and prevent a protracted bout of inflation that is harmful to the well being of societies. And policymakers have reacted, placing heavy if not exclusive emphasis on monetary actions.