How safe is our money?

The war in Ukraine has fanned the flames of inflation. Is this merely a temporary shock – or the start of a new normal?
Inflation: How much do I get for my money today? How much tomorrow? (Image: Keystone)

Be it cash in our pockets, bank deposits, or digital credit on a card or smartphone – money is woven into the fabric of everyday life. These days, we tend to assume that our money will still buy us the same amount of goods or services two months, or even two years, from now. Yet this was not always so. “History tells us that high inflation not only causes huge economic harm but can also inflict immense social and political damage,” explains Professor Hans Gersbach, who holds the Chair of Macroeconomics: Innovation and Policy at ETH Zurich and is also a member of the Board of Academic Advisors to Germany’s Federal Ministry for Economic Affairs and Climate Action.

For the first time since the 1980s, Western industrial nations find themselves once again facing the spectre of higher inflation. The war in Ukraine and the resulting fallout are now likely to fan the flames. In the eurozone, the rate of inflation is currently 7.5 percent (end of March 2022), more than five percentage points above the benchmark of 2 percent. In the US, it now stands at 7.9 percent. One of the few countries to buck this trend is Switzerland, where prices have risen by a mere 2.5 percent during the last year. Given such drastic developments in the eurozone, how safe is our money? Is it merely a temporary shock, exacerbated by the Russian invasion? Or should we expect higher inflation in the longer run? And, if so, how can we best protect ourselves against this risk?

Temporary or permanent?

When it comes to inflation, ETH professor Jan-Egbert Sturm tends to focus on short- and medium-term movements in prices, wages and interest rates. Sturm is also Director of the KOF Swiss Economic Institute, an organisation whose forecasts carry significant weight. He has regular meetings with members of the Swiss Federal Council and the Swiss National Bank (SNB).

Sturm is an empirically-oriented economist. Rather than relying solely on abstract theoretical models, he favours the use of statistics, time series and indices. “Inflation is essentially being fuelled by the rapid economic recovery following last year’s lockdowns and the resulting supply-chain problems,” he explains. The outbreak of the pandemic in spring 2020 was a wake-up call for companies. It taught them that without adequate reserves of essential goods, production can rapidly grind to a halt. “Now we have lots of companies all trying to restock at the same time, which leads to supply bottlenecks and rising prices,” Sturm explains. “But this situation should improve once inventories are replenished.”

«A look at the history books shows that high inflation not only causes great economic damage, but also has enormous potential for social and political destruction.»      Hans Gersbach

Sturm and his colleagues also focus on the basket of goods used to measure inflation. This tracks price changes across a range of consumer goods and services. It turns out that much of the current inflation is down to increased prices for energy, raw materials, and goods that have been in high demand during the pandemic. “People have been prepared to spend more money on computers and TVs, but these are mainly one-off effects that we would expect to normalise over the medium term,” says Sturm.

In normal circumstances, this would indicate that the currently high rate of inflation is likely to be temporary. However, the invasion of Ukraine and the resulting sanctions imposed on Russia are also driving inflation. “Russia is one of the world’s largest suppliers of oil and gas, which means that energy prices have risen even further,” Sturm explains. Moreover, Russia and Ukraine are among the largest exporters of wheat. Following the outbreak of war, prices not only for wheat but also for other crops such as maize and soya have gone through the roof. Sturm says it is still difficult to tell just how quickly and heavily this will impact food prices. But one thing is clear: rising oil and gas prices will further fuel inflation.

A sign of uncertainty

So, where will inflation come to rest in the longer term? This will depend not only on price trends but also on inflation expectations. “When more and more people believe things are going to get more expensive, they start demanding higher wages, which in turn has an impact on prices,” Gersbach explains.

Inflation expectations are measured by canvassing analysts, companies and consumers about future price trends. KOF is among the bodies that publish such surveys. In addition, the expectations of financial market actors can be gauged on the basis of certain market transactions. According to Gersbach, the data is increasingly clear: “For a long time, the financial markets appeared to regard future inflation as relatively low and stable. But surveys have been showing a significant rise in average inflation expectations and a greater spread of opinion for quite some time now.” Moreover, in many European countries, the majority now expects inflation to continue rising – and the current conflict will only reinforce this trend.

Whether this pessimistic outlook further hardens will depend to a large extent, Gersbach and Sturm say, on the monetary policy of the central banks. In response to high inflation in the 1970s and 1980s, most central banks in industrialised countries have become relatively independent of government policy and now focus on maintaining price stability. “The lesson of past inflationary crises is that currency stability is better left in the hands of independent experts,” says Gersbach.

If higher inflation becomes entrenched and inflation expectations move higher, central banks will need to raise interest rates and cut back their generous bond-buying programmes and other interventions in the financial markets. Both economists agree that this would entail substantial risks, especially for the eurozone. “A premature rise in interest rates would threaten the fragile economic recovery,” says Sturm. “And countries with a high level of debt could run into difficulties refinancing those loans.” It could also lead to serious upheaval in the financial markets.

The war in Ukraine and the attendant economic fallout have further exacerbated the dilemma facing central banks. “The coming slowdown in economic growth could well persuade them not to raise interest rates as planned, which would further fuel inflation,” Sturm explains. In a worst-case scenario, there is even the threat of stagflation, an economic phenomenon not seen since the 1970s, which combines high inflation with falling growth and rising unemployment. The extent to which the economic picture further 
deteriorates and the level at which energy prices finally stabilise will depend on how the Ukraine conflict plays out.

«Swiss companies and consumers tend to assume almost zero inflation.»      Jan-Egbert Sturm

So far, the UK and US central banks have signalled a willingness to countenance reduced growth and greater financial market volatility in return for lower inflation. By contrast, the European Central Bank (ECB) remains cautious. Gersbach and Sturm say this is primarily because the ECB is responsible for monetary policy in the entire eurozone and therefore factors in the economic situation of 19 countries. “Yet, if higher inflation proves to be ‘sticky’, the ECB will also have to raise interest rates to protect the value of money,” says Gersbach.

As guardian of one of the world’s oldest and most stable currencies, the SNB has a somewhat easier task than the ECB. “Swiss companies and consumers tend to assume almost zero inflation,” says Sturm. The favourable exchange rate is another factor in the country’s comparatively low rate of inflation: “The strong Swiss franc makes imports cheaper, thereby curbing price increases. Should imported goods become more expensive, the SNB can allow the currency to appreciate slightly to counter inflationary pressures.” What’s more, Switzerland is not especially dependent on heavy industry. For this reason, oil and gas prices have less impact on the cost of industrial goods.

A new monetary system

“In the long run, however, Swiss monetary policy will also face a big unknown,” says Gersbach. He explains that a new monetary system has emerged in the wake of the 2008 financial crisis: “Before the financial crisis, commercial banks only held small reserves with the central bank. But in order to stabilise the banking system and, with it, the economy, central banks have undertaken large-scale purchases of securities from commercial banks and of foreign exchange reserves, as in the case of Switzerland. Over the past 14 years, this has massively increased the level of reserves that commercial banks hold with central banks.”

Using these reserves, the banks could greatly expand their lending or the buying of securities, thereby creating new bank deposits and thus increasing the money supply, but without risking liquidity problems. To what extent this will happen and whether this newly created money will lead to higher inflation or even another financial crisis is a matter of debate, says Gersbach. With money, there’s always uncertainty, and therefore risk.

This text reflects the situation in the first week of March 2022.

This text appeared in the 22/01 issue of the ETH magazine Globe.


Hans Gersbach is Professor of Macroeconomics: Innovation and Policy at ETH Zurich and a founding member of the ETH Risk Center.

Jan-Egbert Sturm is Professor of Applied Macroeconomics and Director of the KOF Swiss Economic Institute at ETH Zurich.