What is behind the current rises in inflation, and consequent cost-of-living crisis? Adeetya Tantia explains
Inflation is back with a vengeance. After consistently low inflation rates for the past 30 years, the UK and the rest of the world are experiencing extremely high inflation rates, with the Consumer Price Index touching 8.2% in June 2022.
What is the cause of this high inflation? Various sources tell us different stories: it’s a supply shock; it’s increased demand due to the COVID-19 payments; it’s because Putin invaded Ukraine. In reality, the answer is: all of the above.
The pandemic did give some people more disposable income, primarily due to investment from the stock market, which rallied in the latter half of the pandemic after falling off a cliff in March 2020. This income was spent on physical goods, rather than services such as restaurants and cinemas, which were largely closed during lockdown.
The demand for physical goods was never met because China – which makes most of them – also shut down. In fact, the country still has a harsh COVID-19 lockdown policy and is following a ‘zero-COVID’ approach, which has fuelled the supply shock.
Economists predicted that supply would return to normal levels once lockdowns eased – but ships are still waiting to dock at ports, and factories are still running under capacity. It is not easy to replace labour and parts in a fragile supply chain that essentially evaporated for two years. This is where the sustained supply shock comes in.
The war in Ukraine also played its part, with countries trying to wean themselves off Russian oil and gas – partly by sourcing it from elsewhere, effectively raising prices for gas, fuel and even food. In addition, wages have not kept up with the increased inflation, leading to the loss of purchasing power that most are now feeling.
This confluence of factors has led to a sustained inflationary rise in prices that has plunged the world into a cost-of-living crisis.
To counter this, central banks have tried increasing interest rates to make the cost of credit higher – essentially applying the brakes on the economy. This wasn’t done earlier because most economics textbooks recommend riding out a supply shock-induced inflation rise rather than reacting to it. However, the pandemic was a once-in-a-lifetime situation that wasn’t covered by these books. Interest rates are expected to rise steeply in the coming months.
The insurance industry has been impacted by this in various ways, as claims are now more expensive than was expected when policies were underwritten. The increased cost of labour and prices push up claims costs, which will likely hit double digits this year. This increase also affects premium prices on renewals and new policies, leading to already cash-strapped individuals either having to pay more for their insurance or even skipping payments, risking their coverage.
This may also lead to underinsurance: if the sum insured doesn’t change for a particular property over the policy term, the rise in inflation could lead to the cost of the property exceeding its coverage. Policies with riders of inflation protection would lead to high rises in the same, throwing off insurers’ previous reserving and pricing calculations.
With the rises in cost inflation not commensurate with wage inflation, the risk for borrowers increases, which may lead to higher default rates and thus more claims for insurers offering credit insurance. The crisis might even increase fraud rates, given people’s situations.
Pension payments set to be indexed with inflation, usually capped at 5%, would also be affected severely. This would affect both insurers – which did not anticipate such high inflation – and pensioners, who lose purchasing power as inflation exceeds 5%.
Investments made by insurance companies will also be impacted by this inflation increase, eroding gains that are not protected – especially in the bond markets, as equity markets have done well with record corporate profits this year.
The cost-of-living crisis is here to stay, and even when inflation is brought under control again, the loss of purchasing power due to anaemic wage inflation will leave people worse off than before. We don’t know when this crisis will be resolved or at least eased, but it will likely remain a teaching moment for decades to come.
Adeetya Tantia is student editor
Image credit | Simon-Scarsbrook