Exploring The Distributional Effects of Inflation Pre- and Post-Covid

By Szilvia Rosental and Jiaming Liu.

Introduction

Earlier this year, poverty campaigner Jack Monroe’s claim that the ONS’ CPI measure “grossly underestimated” inflation and price increases for the poorest households created a lot of media attention. (BBC, 2022) The ONS restarted their publication of inflation data broken down by income in response, concluding that even with heightened Covid inflation, Monroe’s claims of 344% price increases for low-income households (BBC, 2022) — who tend to buy lower-priced products — was unrealistic, with “similar” recorded rates of inflation for different groups (Giles, 2022). Although an inflation rate difference this dramatic is not likely, a difference that is more significant than the ONS reports does not seem outlandish.

Famously, Covid-19 exacerbated inflation rates, especially in the food and beverages category, which makes up a much larger share of a low-income household’s expenditure. One research paper indicates an annual inflation rate of 1.12% for low-income households in 2020, compared to 0.57% for high-income households (Cavallo, 2020).

Although not as drastic as Monroe’s statement, such a difference heightens already rampant wealth inequality and is incredibly important for policymakers to consider when implementing programmes for households facing income disruptions or for redistributive purposes (Blundell et al., 2020). This becomes even more poignant when considering inflation is expected to peak at 7% in mid- to late-2022 due to Ofgem’s increase of the default energy tariff price cap (Romei, 2022). Furthermore, all households experience a decrease in their purchasing power during inflationary episodes, and low-income households who tend to hold the majority of their wealth in fiat money, would be affected more by an increase in taxes (implemented to raise government funds for Covid recovery, for example) than high-income households, tending to hold both capital and fiat money (Thalassinos et al., 2012).

The negative redistributive effect of inflation is not a topic with rich literature or empirical research, but it is an important one for policymakers to consider in order to have a good chance of curbing rising wealth inequality, which is currently at its peak with the richest 10% controlling 52% of global income, while the poorest 50% controls only 8% (Elliot, 2021). This article aims to further explore the distributional effects of inflation pre- and post-Covid and theorise ways policy could be shaped to mitigate this.

Inflation Rates Pre-Covid

Prior to 2019, inflation rates had been gradually dropping for decades as globalisation eased production costs, and an ageing population led to less consumption relative to growth in income (Avent, 2021). As expectations formed around the declining rate, economies weakened further as consumers decreased their expenditure, waiting for prices to keep falling, with the Eurozone hitting an annual CPI of 0.7% in 2013 (The Economist, 2013). Slow economic growth, less lending and depressed wages further worsened welfare.

However, given the overall declining trend of inflation before the pandemic, the annual inflation for the bottom quintile income group in the US was still found to be 0.4% higher between 2004 and 2015 (Jaravel, 2021). This finding is likely a result of how the consumption baskets of high- and low-income households differ. Even before Covid inflation, ONS statistics are capable of underestimating inflation for different groups of shoppers. The ONS checks prices in big supermarkets as well as discounters such as corner shops, Aldi and Lidl, since big chains tend to price-check against them. If an item is discontinued, the ONS looks for a similar-quality replacement product, however, in the case of a change in quality, a different product is bought (‘breaking the price chain’), and the price difference between the original and this new product is not reflected in the inflation calculation. Shoppers looking for the cheapest products therefore can be faced with a big price jump that is not accounted for in the statistics (BBC, 2022). Moreover, pandemic supply shortages would in certain cases force customers to buy specific brands of products (those available). Deviations like this from a low-income household’s grocery budget, for example, can have a large effect on disposable income and savings, whereas the same issue might not be as significant for households with larger incomes.

Income Redistribution Due to Expected Vs Unexpected Inflation

Inflation affects all income sources differently, with heterogeneous effects on households. As a result, inflation can modify the income distribution, and targeted policies may not be targeting those who would benefit the most. While high inflation eroding purchasing power negatively impacts all households, low-income households suffer the worst welfare outcomes. Moreover, these households are generally more vulnerable to short-term financial shocks and if the effect of high Covid inflation is understated, they would experience a larger contraction in their income than headlines would suggest (Blundell et al., 2020).

How sudden-rising inflation during the pandemic has impacted inequality is thus worth attention. Inflation recently reached a 30-year high of 5.5% in the UK, with core inflation jumping to 4.4% in January 2022. Previous forecasts of CPI inflation fell short, and the Bank of England now expects inflation to peak at 7% in 2022 after Ofgem raises its default energy tariff price cap (Romei, 2022).

It is also important to consider the costs of inflation more generally. Money illusion describes the population’s tendency to think in nominal rather than real terms and therefore view expected inflation in prices as more harmful than it may actually be. In contrast, a rise in wages is viewed as a well-deserved reward instead of a consequence from inflation more generally. The Shiller (1997) survey demonstrated that 77% of those polled viewed a decrease in buying power as the worst consequence of inflation, even though only 12% of economists agreed. Although general costs of inflation involve menu costs and a short-term dissonance between relative prices and wages — which may fall between changes, therefore decreasing purchasing power slightly –, overall, expected steady inflation does not necessarily accelerate the growth of the income gap, hence why central banks target stable inflation.

This article emphasizes the difference between expected and unexpected inflation. Contracts written in a given year (especially if they stretch into the long-term) tend to incorporate expected inflation, although they specify nominal payments in most cases. It is known that in a period of unexpected inflation, the resulting uncertainty impedes financial planning and distorts the real value of such contracts, however nominal contracts are nevertheless widespread and may even be optimal given certain conditions (e.g., similar ex ante preferences over future consumptions between consumers) are satisfied (Freeman and Tabellini, 1991). Consequently, when inflation is unexpected, individuals who long or short nominal assets are affected differently, and wealth is thus redistributed arbitrarily. For example, pensioners who own nominal assets experience an overall loss of real value in the asset, without having incorporated this risk of unexpected as opposed to expected inflation into the contract at the time of agreement. Economists generally consider this redistribution as unfair as a result, and there is a net negative effect for individuals as people in general tend to be risk averse and dislike uncertainty (Hazell, 2022).

It is also discussed that a change in the rate of inflation intensifies income distribution inequality (Budd and Seiders, 1971). The empirical evidence supports the same conclusion: low-income individuals experience a further decline in income as inflation rises, lowering their real minimum wages (Tyson, 1998). Furthermore, lower-income households, who hold a large portion of their wealth in fiat money, would be taxed more heavily than higher-income households, who tend to hold both capital and fiat money. This implies that inflation will exacerbate income inequality (Thalassinos et al., 2012).

Although this article argues inflation exacerbates income inequality, it has been shown to also reduce inequality in net worth distributions (Budd and Seiders, 1971). This is because inflation does not affect all types of net worth and income sources equally, such as labour income, capital income, and government transfers (Monnin, 2014). This relationship was tested by experiments using a headline inflation simulation that ignores the divergence of sectoral inflation rates and the non-linear effect of changes in the inflation rate on output growth, however, and so the direction and magnitude of the discussed redistributive effect may deviate from the practical outcome (López-Villavicencio and Mignon, 2011).

Drivers of Covid-19 Inflation

While it is still too early to definitively determine the drivers of Covid-19 inflation, potential factors include significant supply shortages and disruptions to the production process alongside panic-buying and hoarding on both an individual and international scale during the lockdown phase, and the eventual rebound and exacerbation of demand overwhelming still-struggling supply once lockdowns started to unravel (Ebrahimy et al., 2020). Imports from Asia surged, but supply could not keep up, owing to disruptions caused by China’s zero-tolerance Covid-19 containment policies (Kennedy, 2021). Massive stimulus programmes implemented to prop up demand have arguably fuelled inflation further, as the balance-sheets of the Fed and the ECB grew by more than 40% and 12% respectively (The Economist, 2020).

However, pandemic inflation rates are not appropriately and accurately measured since the baskets used to calculate the Covid Consumer Price Index (CPI) will no longer be representative of actual spending; specifically, some cost increases due to supply disruptions and stockpiling may go unrecorded (Blundell et al., 2020). This suggests that the gap between what the CPI aims to measure (the increase in the prices of goods and services), and what it is commonly thought to measure (the cost of maintaining a particular standard of living) will be much larger than usual. As inequality is often measured as the variance of the cost-of-living, Covid-19 inequality expectations are also likely to deviate from the perceived value.

Recognizing this potential measurement bias, an experiment was conducted to update basket weights based on high-frequency spending data estimates, resulting in the conclusion that Covid CPI is generally higher than both the all-items CPI and Core CPI (Cavallo, 2020). Taking the United States as an example, core CPI was 0.13%, while Covid CPI increased to 0.95% percent. This is primarily due to an increase in food and beverage spending, which is experiencing higher inflation, and a decrease in the weight of transportation, which is experiencing significant deflation. However, there is no universal explanation; Cavallo emphasizes that the basket bias is affected not only by changes in the basket weights, but also by the CPI sectoral inflation rates experienced by each country as well as the structure of the CPI more generally (Cavallo, 2020).

J.P. Morgan and other influential financial institutions have argued that current high inflation is transitory, and a gradual decline is expected in 2022. This is based on the assumption that demand-supply imbalances will fade by the end of year and that major economies will have responded with monetary policy. Assuming inflation expectations remain well-anchored, consumers should shift their spending away from goods and toward services, while supply chain tensions ease. Goods price inflation may thus be transitory. In tandem with the recent tendency of the Fed, Bank of England and ECB’s monetary policy to be less expansionary, it is a valid assumption that inflation should reduce later this year.

We are very concerned with this optimistic view, however, due to the impacts of two decades of wage growth, rising rents, and generally higher inflation expectations. This would imply inflation levels well-above 2% for the remainder of this year. Hence, it is still uncertain to assess whether high pandemic inflation levels are transitory or long-lasting. The possibility of having long-lasting high inflation could be even more damaging for low-income households and therefore inequality.

Central Bank Independence and Monetary Policy on Inflation and Inequality

Central bank independence (CBI) measures how independent a country’s central bank is from government and fiscal policy. It’s widely perceived to be a positive thing as it reduces the chances of politicians being swayed by inflation bias — the tendency to raise inflation rates in order to spark an economic boom to get re-elected, while promising to lower inflation rates in the future (often not a credible promise).

Some research has argued that CBI exacerbates income inequality, although research regarding monetary policy and inequality is still in its infancy (Ilzetzki et al., 2021). In early 2021, World Bank Group (Poverty and Equity Global Practice) tested this argument using a panel dataset covering up to 121 countries from 1980 to 2013 and found out that an increase of CBI by one standard deviation, ceteris paribus, coincided with a 0.3% decline in the share of income earned by the bottom decile and a 1% growth in the income share of 80%-90% of the population as well as the top decile. Although it could be argued that this shift in income from the bottom half of the population to top earners was a result of the change in CBI, however, many observations of CBI’s effect on macroeconomic aggregates are a result of correlation not causation, and the impact of CBI cannot therefore be definitively concluded.

However, it is interesting to delve deeper into how CBI can be a confounder in a causal relationship between higher inequality and another variable. The three categories we have identified are the (1) financial, (2) labour, and (3) social channels.

Firstly, CBI increases the temptation to liberalize financial markets and fuel private debt (Aklin and Kern, forthcoming). The rising trend of the ‘shareholder value model of corporate governance’ — which defines the ultimate measure of a company’s success as the extent to which it enriches shareholders — increases income growth for the top 1 percent of income earners but does not affect the economic fortunes of the next 9 percent, driving up pre-tax income inequality (Huber et al., 2020).

Secondly, CBI implies that governments cannot stimulate employment by inflating real wage through monetary policy intervention, such as keeping the interest rate unchanged until witnessing a certain percentage increase in the real wage. Therefore, structural labour market reforms that help avoid an uptick in unemployment after CBI have become increasingly important. Reform aims typically consist of removing wage stagnations and structural impediments to reach full employment (Thelen, 2014b). This has been observed in several European countries entering the European Monetary Union, when they promoted wage flexibility by dismantling protective labour market institutions (Bertola, 2016) — specifically, governments fought against unionisation that builds the backbone for downward wage rigidities. The erosion of workers’ bargaining power ultimately fuels the rising level of income inequality (Jaumotte et al., 2015).

Finally, the more independent a central bank is, the more a balanced budget is preferred in the long run. Bodea and Higashijima (2017) broadly argue that a preference for a balanced budget could lead to a central bank curtailing the government’s ability to greatly increase spending, even for welfare. There could therefore be a link between a higher CBI and higher inequality as an indirect consequence. Interestingly, the above paper only found this effect in democracies and during non-election years under a left-wing government.

This is widely debated however, and CBI is often viewed by economists as positive. Many seemingly causal relationships to macroeconomic aggregates or high inflation could simply be a result of correlation, not causation.

The chart below gives a concise summary of these three channels:

Wealth Inequality More Generally

Wealth inequality has been widening for the past 3 decades due to the globalisation of trade and finance. Interestingly, although inequality between nations has been declining, wealth gaps withing countries are expanding (Elliott, 2021). The welfare and development of millions is at risk, as only the richest benefit. Income tax rates in wealthier countries have fallen by 23 percentage points over 4 decades (Phan, 2020). Less progressive tax systems among other factors mean that the wealthier a person becomes, the easier it is to generate and accumulate further wealth.

Closing the wealth gap is a widely discussed issue at the moment in politics, however, although the role that high inflation may play or whether low-income households’ ability to respond to dramatic changes in prices is overestimated has less research and discourse. It is incredibly important therefore, that measures of inflation (with the CPI being the most often referenced and used) are accurate, or that their biases are known since otherwise any programmes aiming to adjust cost-of-living may have differing effects from those originally intended.

Thankfully, the shortcomings of CPI are well-understood and there is current research being conducted on possible improvements to the measure. Of course, the issue of how representative the CPI can be for households after Covid-spurred consumer behaviour changes remains. Substitution bias (the fixed basket not capturing the product substitutions households conduct in response to changes in relative prices of goods and services to minimise expenditure) and new product bias (new innovations not being introduced into the index until they become commonplace, therefore not capturing price decreases and quality increases) are being addressed by planned changes to the measure (Wallace and Motley, 1999). Moreover, more frequent updates to the expenditure weights obtained from consumer surveys, alongside an increase in the survey sample size should allow the basket of goods used for the index to be more representative and allow faster introduction of new products than before. (Wallace and Motley, 1999). The ONS has also published some experimental statistics on subgroup estimates as an “early indication of the impact of inflation on different household group” (ONS, 2022).

Conclusion

As there are not yet any definitive answers to the extent of the distributional effects of inflation on the population, policymakers should continue to be alert to the possibility of negative effects on the income distribution, keeping in mind the bias inflation measures are distorted by when implementing any programmes intending to adjust cost-of-living, especially as the pandemic continues and further biases are introduced. Provided that research on this issue continues and national statistical institutions are open to criticism from both academics and the public, we will hopefully see a gradual closing of the wealth gap, and a smoothing of any negative distributional effects inflation may have.

This article was written by two of our economic research analysts Szilvia Rosental and Jiaming Liu and was reviewed by our 2021–22 Head of Economic Research, Joe Marshall.

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