Deutsche Bank economists say "this time is different for inflation" and policy makers could be facing their most challenging time in about 40 years.
In a new report titled: What's in the tails? - Inflation: The defining macro story of this decade the bank's senior economists note the globally receding fear of inflation and rising levels of government debt that shaped a generation of policymakers.
"Replacing it is the perspective that economic policy should now prioritise broader social goals," say the bank's chief economist David Folkerts-Landau, global head of economic research Peter Hooper and head of thematic research Jim Reid.
Their report debates whether inflation is transitory or the pursuit of "these important social priorities by governments" will mean inflation will have longer-term and far reaching implications for the health of the global economy.
"Either way, higher inflation is coming and policymakers are about to face their toughest battle in 40 years," the economists say.
They say that two of the biggest historic constraints on macroeconomic policy – inflation and debt sustainability – are increasingly perceived as not binding. In turn, the removal of these constraints has opened the door for new goals for macro policy, which go far beyond simply stabilising output across the business cycle. This changing approach to macro policy has been formalised in the Federal Reserve’s operating procedures, making a broader interpretation of its mandate possible.
"Unlike in previous eras, when it was common practice to pre-empt inflation overshoots with higher rates, today’s Fed has said they want to see actual progress, not just forecast progress. The new average inflation targeting approach only increases tolerance for inflation.
"Where the US leads, others tend to follow. Even in Germany, with its reliable fiscal discipline, there is growing support for to reform the constitutional debt brake in order to permit more deficit spending. And although in aggregate the EU’s fiscal stimulus has been more limited than that seen in the US, the arrival of the €750bn Recovery Fund financed by collective borrowing potentially opens the way for further such packages in response to future crises. It is hard to see the ECB stepping back from helping to finance such fiscal investments in the continent or moves to promote further integration.
Fiscal injections 'off the charts'
"In short, we are witnessing the most important shift in global macro policy since the Reagan/Volcker axis 40 years ago. Fiscal injections are now 'off the charts' at the same time as the Fed’s modus operandi has shifted to tolerate higher inflation.
"Never before have we seen such coordinated expansionary fiscal and monetary policy. This will continue as output moves above potential.
"This is why this time is different for inflation."
The Deutsche economists says that even if some of the transitory inflation ebbs away, "we believe price growth will regain significant momentum as the economy overheats in 2022".
"Yet we worry that in its new inflation averaging framework, the Fed will be too slow to damp the rising inflation pressures effectively. The consequence of delay will be greater disruption of economic and financial activity than would be otherwise be the case when the Fed does finally act. In turn, this could create a significant recession and set off a chain of financial distress around the world, particularly in emerging markets.
No soft landings
"History is not on the side of the Fed. In recent memory, the central bank has not succeeded in achieving a soft landing when implementing a monetary tightening when inflation has been above 4%."
The economists say few people still remember "how our societies and economies were threatened" by high inflation 50 years ago.
They say the most basic laws of economics, the ones that have stood the test of time over a millennium, "have not been suspended".
"An explosive growth in debt financed largely by central banks is likely to lead to higher inflation," they say.
"We worry that the painful lessons of an inflationary past are being ignored by central bankers, either because they really believe that this time is different, or they have bought into a new paradigm that low interest rates are here to stay, or they are protecting their institutions by not trying to hold back a political steam roller.
"Whatever the reason, we expect inflationary pressures to re-emerge as the Fed continues with its policy of patience and its stated belief that current pressures are largely transitory.
"It may take a year longer until 2023 but inflation will re-emerge.
"And while it is admirable that this patience is due to the fact that the Fed’s priorities are shifting towards social goals, neglecting inflation leaves global economies sitting on a time bomb.
"It is a scary thought that just as inflation is being deprioritised, fiscal and monetary policy is being coordinated in ways the world has never seen. Recent stimulus has been extraordinary and economic forecasting, which is difficult at the best of times, is becoming harder by the day. Fractured politics amplifies the problem. Needless to say, the range of global outcomes over the coming years is wide.
"When central banks are eventually forced to act on inflation, they will find it themselves in a difficult, if not untenable, position. They will be fighting the increasingly-ingrained perception that high levels of debt and higher inflation are a small price to pay for achieving progressive political, economic and social goals.
"That will make it politically difficult for societies to accept higher unemployment in the interest of fighting inflation.
"Eventually, though, any social priorities that policymakers have will be set aside if inflation returns in earnest. Rising prices will touch everyone. The effects could be devastating, particularly for the most vulnerable in society.
"Sadly, when central banks do act at this stage, they will be forced into abrupt policy change which will only make it harder for policymakers to achieve the social goals that our societies need. Low, stable inflation and historically low interest rates have been the glue that have held together macro policy for the last three decades. If, as we expect, this starts to unravel over the next year or two, then policymakers will face the most challenging years since the Volcker/Reagan period in the 1980s," the economists say.