As temperatures rise and countries scale back their decarbonisation efforts, we must face a reality that central banks cannot fix
Inflation is essentially a tax on consumption – and it hits the poor hardest because they consume a larger share of their income and the rich consume a smaller share.
That’s one reason for fears about Donald Trump’s tariffs, which will disproportionately affect the poor. When the 90-day pause regarding tariffs ends, we can expect prices to rise, and significantly so.
This is because, firstly, trade is dominated by intermediate goods rather than finished goods that cross borders and are taxed several times along the way, making them highly inflationary. Second, while the tariffs of the first Trump administration could have been more easily absorbed through exchange rates and producers, tariffs of this magnitude cannot be absorbed. Producers and consumers have to take the hit, and that means higher prices. It looks like the poor will again be hit hardest.
But if Trump’s tariffs disappeared forever, would we return to a world of stable prices? The findings from our new book ” inflation: a guide for those who win and those who lose” show that this is sadly not the case, and there are three reasons for this.
Firstly, how we think about inflation and how we react to it. We have identified four different ways in which the public and central banks have talked about the causes and consequences of inflation over the past few years. The first story is the textbook idea that “the government is spending too much money”. The second focuses on wages pushing prices up – the labour market story. Both of these stories see inflation as a consequence of demand outstripping supply. Consumers demand too much because governments put too much money in their pockets, and workers demand higher wages despite no significant improvements in productivity. If production fails to keep up with the surge in demand, the inevitable consequence will be higher prices.
The other two stories we identified look at inflation in reverse. Inflation is caused by the supply side of the economy. There is the story of “supply shocks”, where unexpected events such as Covid or the war in Ukraine push prices up, and they stay that way until the economy adjusts to them. Finally, there is the story of corporations in concentrated markets using inflation as a cover to raise prices.
There is evidence in favour (and against) all four causal stories. But policymakers tend to focus on the first two. As a result, central banks have raised interest rates, which can be effective in reducing inflation when it is demand-driven, but can do little if inflation is caused by an exogenous shock such as Covid or war.
What was interesting about inflation in the 2020s was that the last two stories-supply shocks and opportunistic corporations-turned out to be just as, if not more, important than the first two.
But does all of this have anything to do with future inflation? No, and that brings us to reason number two.
The Trump administration has recently declared war on climate change research in the federal government and the broader US research community, and doubled down on pressure on carbon-based business models. But wanting to get rid of the problem won’t make it go away. The true drivers of future inflation are not just tariffs, but also the climate crisis and the rollback of the states’ decarbonisation efforts.
Climate change is already affecting prices. The first driver of this is the insurance markets. The combination of massive increases in the cost of damage from droughts, wildfires and floods has caused insurance costs to soar in many countries. Some insurers have decided to cut coverage in US states such as California and Florida, leaving those states on the hook for losses they will never be able to cover. Realising this, reinsurers – companies that protect insurance companies – are taking their coverage away from insurers, leading to long-term price increases. The consequences extend far beyond the insurance markets. In the U.S., you can’t get a mortgage or build without insurance. Housing is already critically scarce. Prices can only go up.
The climate crisis is also having a long-term impact on what we eat. The Potsdam Institute for Climate Impact Research and the European Central Bank have conducted the first systematic assessments of how much climate change will affect inflation because of the impact on food supplies. Assuming the projected temperature rise by 2035, which is likely to be an underestimate, food inflation will rise by 0.92 to 3.23 per cent per year, while overall inflation will rise between 0.32 and 1.18 per cent per year. Forest fires in the US and recent prolonged droughts and crop failures in Europe are just the thin end of this inflationary wedge.
Finally, there is the question of how others are reacting to the US disrupting the current world order. The nationalisation of a British steel company, the decision to expand Heathrow Airport, the increase in defence spending-all suggest that our attempts to decarbonise the economy are being put on hold in the name of adjusting to these new realities