Originally published at Project-Syndicate | Jan 31st, 2024
There is good reason to believe that temporary increases in inflation, driven by large swings in relative prices, will become more common. In this new era, how policymakers think about inflation must apply the lessons of past experience to current price conditions and, on that basis, attempt to anticipate what the future may hold.
LONDON – After reaching its highest level in decades in mid-2022, inflation in the United States and the eurozone fell sharply over the second half of last year. But, in December, the headline consumer price index (CPI) in the US and the Harmonized Index of Consumer Prices (HICP) in the eurozone rose slightly. Was it an aftershock or a foreshock?
The speed of last year’s disinflation surprised many, not least central banks, which have insisted that it is too early to claim victory. But are they urging caution because they believe that there is persistent underlying inflationary pressure – which might explain the recent uptick – or are they simply acknowledging uncertainty?
Markets seem to be embracing the latter explanation, anticipating that both the US Federal Reserve and the European Central Bank will start cutting interest rates in the spring. This sentiment is not unfounded: if we consider the six-month annual percentage change in core inflation – a timelier indicator of underlying inflation than the 12-month change – both the US and the eurozone have brought inflation back down to their 2% target. The evidence points to a persistent decline, regardless of the recent (small) increase in headline figures.
This means that price stability may well have been re-established within three years, which by most definitions would make the latest bout of inflation “transitory.” But let us not get caught up in the rather pedantic debate between those who argued that inflation would be short-lived and those who anticipated that it would be “persistent.” Instead, we should seek to understand the mechanisms that pushed inflation up and then down, in order to draw lessons for responding to future price volatility.
Monetary policy is a powerful tool; it can always bring inflation down eventually. And central banks are often encouraged to get to work right away: if they do not intervene quickly and firmly, the logic goes, inflation expectations might become “unanchored,” fueling a wage-price spiral that leads to employment losses. This was the story of the 1970s.
But aggressive disinflation carries costs, and reining in inflation can undermine economic growth and financial-sector performance. The details depend partly on the factors driving inflation: if the culprit is an uneven supply shock (associated with large relative changes in prices), the costs of disinflation are likely to be higher than if the cause is a surge in aggregate demand.
This brings us to the latest bout of inflation. In the eurozone, it was probably driven mostly by uneven energy and supply shocks, which were transmitted gradually through economic sectors, starting with manufacturing and then moving to services. This was likely the case in the US, as well, but to a lesser extent.
In both economies, pressure from wage “catch-up” was modest; there was no sign of a wage-price spiral. And, during the disinflationary phase, the labor market has not weakened significantly in the US or in Europe. In other words, both inflation and disinflation have played out in goods markets, not labor markets.
This interpretation is supported by the fact that, though the decline in core inflation (which strips out volatile food and energy prices) has lagged behind the decline in headline inflation, core inflation is now converging to the 2% target. This surprisingly sharp fall occurred before economic activity began to soften (likely as a result of monetary tightening). According to Eurostat, quarterly GDP growth in Germany was zero in the second and third quarters of 2023 and it is now estimated to have fallen to -0.3%. The euro area average has fared a bit better with no growth in the fourth quarter after -0.1% in the third. Demand for bank loans, according to the ECB bank lending survey, is now weaker than during the 2011 sovereign-debt crisis.
There is good reason to believe that temporary surges of inflation, driven by large swings in relative prices, will become more common. For starters, an energy transition is underway, so increases in energy demand may well run up against supply constraints, which are even more likely amid rising geopolitical tensions; the recent attacks by Houthi rebels on ships in the Red Sea may offer a glimpse of what is to come.
Under these circumstances, straightforward inflation targeting might prove inadequate. Central banks should be considering whether, in the face of uneven supply shocks, they should give themselves more time to bring inflation back to target. After all, the standard prescription of aggressive monetary-policy tightening – which works by depressing aggregate demand – will prove less effective in reining in inflation caused by uneven supply-side shocks. And it will carry high costs. Beyond undermining financial stability and employment, excessive tightening hampers relative price adjustment, thereby reducing the efficiency of resource allocation. If monetary conditions remain tight for a prolonged period, investors might be discouraged from pursuing longer-term investments, such as in green technology.
In short, when inflation is driven by supply constraints, monetary tightening alone is not the answer. Fiscal-policy action – and monetary and fiscal coordination – will also be needed. We are not living in the 1970s or the 1990s. How we think about inflation must apply the lessons of past experience (including from the recent past) to current price conditions and, on that basis, attempt to anticipate what the future may hold.
Lucrezia Reichlin: A former director of research at the European Central Bank, is Professor of Economics at the London Business School.