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What history tells us about pandemics’ impact on inflation?



HOW will inflation dynamics unfold following the COVID-19 pandemic? This question has recently attracted a lot of attention in both policy and academic circles, yet it is difficult to answer because pandemics are a mix of demand and supply shocks that drive inflation in opposite directions (Baqaee and Farhi 2020). Moreover, the extent to which the pandemic affects inflation further depends on hysteresis effects, which leave permanent scars on the economy, and countries’ ability to adjust to the post-pandemic economy. Although inflation has recently picked up in some countries, this may likely be driven by transitory factors. The literature also provides little guidance, as it has focused mostly on the short-run economic impact of pandemics (e.g. Eichenbaum et al., 2020a, 2020b, 2020c, Brinca et al. 2020). Less is known about its potential long-run effects.

  In our recent work (Bonam and Smădu 2021), we provide evidence about the long-run effects of pandemics on trend inflation in Europe. We use historical data since the 14th century (from Schmelzing 2020), which covers 19 major pandemic events and inflation series for six European countries: France (1387-2018), Germany (1326-2018), Italy (1314-2018), the Netherlands (1400-2018), Spain (1400-1729, 1800-2018), and the UK (1314-2018).

  Given that aggregate European inflation (Figure 1) fluctuated strongly over the recent centuries, we focus on the Kalman-filtered trend of inflation. Using this series also helps isolate the impact of pandemics from the many short-run disturbances that affect inflation dynamics. The vertical lines in Figure 1 mark the end of major pandemic events. These dates are taken from Jordà et al. (2020) (hereafter ‘JST’), who classify major pandemics as pandemics resulting in at least 100,000 estimated deaths.

Long-run effects of pandemics on trend inflation

  Our empirical approach closely follows JST, who use a local projection model to study the effects of pandemics on the natural rate of interest. Our main contribution is that we focus instead on the impact of pandemics on trend inflation. As in JST, we include a dummy variable that equals 1 in years when a major pandemic ends. To control for other factors that might influence the behaviour of trend inflation, we include global GDP growth and a dummy accounting for wars resulting in more than 20,000 deaths (these data are all taken from Schmelzing 2020).

  Moreover, we add ten lags of these two control variables and of trend inflation.

  We find that trend inflation falls significantly below its initial level for nearly a decade (Figure 2). This decline meets its trough after 13 years since the pandemic event has ended, at which point trend inflation is 0.6 percentage points lower than if the pandemic had not occurred. It takes about two decades before trend inflation reverts back to its pre-pandemic level. This striking result suggests that, historically, pandemics have had a significant and long-lasting effect on economic activity.

  This depressing effect of pandemics on aggregate demand may occur via heightened uncertainty that increases precautionary savings and lowers investment demand (Stiglitz 2020). This channel is consistent with Kozlowski et al. (2020) who show that the COVID-19 pandemic may entail long-run economic costs due to the ‘scarring of beliefs’, i.e. a persistent change in the perceived probability of extreme negative shocks in the future. Moreover, JST report a significant and persistent decline in the natural rate of interest following major pandemics, likely reflecting a rise in (precautionary) savings and decline in investment demand. Finally, if nominal and real frictions hinder an efficient reallocation of resources needed to adjust to the post-pandemic economy, productivity might drop (Bilbiie and Melitz 2020), exerting downward pressure on potential output and, ultimately, trend inflation.

  While our model assumes time-invariant coefficients, structural changes (including in the monetary and fiscal regimes) are likely over the span of 700 years, which may bias our results. Nevertheless, our findings survive several robustness checks. First, the long-run decline in trend inflation following a pandemic is observed not only at the aggregate level, but also in several major European countries (Figure 3), except for Spain. Second, by splitting the data based on the duration and severity of the pandemics in our sample, we show that the more prolonged and severe are pandemics, the more pronounced and persistent are the associated negative effects on trend inflation

  Finally, as in JST, we compare the impact on trend inflation of both pandemics and wars. As shown by Figure 5, while pandemics tend to exert a negative impact on trend inflation, wars have historically been followed by a persistent rise in underlying inflation. This qualitative difference between the impact of wars and pandemics on inflation substantiates that our results are driven by pandemics and not wars. As argued by Daly and Chankova (2021), wars typically spurred aggregate demand through debt-financed war- and reconstruction-related expenditures, yet impaired aggregate supply through the destruction of physical capital, thereby fuelling investment demand during the post-war years. Also, governments often relied on money printing and inflation to cover war-related costs, avoid debt issuance and potential surges in interest rates.

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