By Agustín Carstens*
Inflation is back. And it is threatening to stay. Only continued strong and decisive action by central banks can prevent risk from becoming reality.
After years of undershooting central bank targets, inflation has moved well outside the comfort zone of households, firms and policymakers alike. The war in Ukraine pushed up raw material and energy prices, adding to inflation already fanned by the fiscal and monetary response to the pandemic. With price rises now broadening across sectors and countries, these developments may herald a new era of persistently high inflation.
In our latest Annual Economic Report, we at the Bank for International Settlements take a look “under the hood” of the inflation process to examine more closely what makes its engine work.
We examine why and how changes in the price of items in a typical shopping basket can morph into broader-based inflation. We identify two distinct phases of inflation with quite different characteristics and behaviour.
When inflation is low for a long time, it fades from the public consciousness. Even jumps in the prices of common purchases like food and petrol do not leave much trace in the longer term, and do not affect expectations of future inflation. Inflation stabilises itself at a low level. This has been the situation in advanced economies for the last two decades.
But if individual price increases are large enough and occur often enough, people take notice. In such an environment, and particularly with supportive monetary and fiscal policies, the psychology of high inflation takes hold. People start to demand higher wages to recoup losses in spending power. They take steps to protect themselves from expected further price rises. They try to automatically link their wages to inflation. Similarly, with high inflation, firms have more incentives to raise prices to offset squeezed profit margins.
With wages chasing prices, and prices chasing wages, a damaging and self-reinforcing increase in inflation can follow. Once such a wage-price spiral sets in, the momentum is hard to stop. High inflation begets higher inflation. At that point, it is much more difficult to shift back to a low- inflation environment: it takes more effort to slow down the vehicle once its cruising speed has increased.
We are approaching such a turning point now. In many case, central banks have already acted decisively to prevent the shift from a low- to a high-inflation era. Now they must see this through.
Hitting the brakes, rather than simply taking the foot off the pedal, might be jarring to the economy. But it is worth it if it prevents an even sharper slowdown – or worse, a crash – down the road.
The current situation is admittedly a tricky one for central banks around the world. Growth prospects are darkening. We may even see inflation combine with stagnant growth to revive the spectre of global stagflation. The current combination of high inflation coupled with historically high debt levels is unprecedented. With the prices of houses and other assets elevated and rising, borrowers and the economy in general are more sensitive to interest rate rises.
But the priority must be preventing high inflation from settling in. We must heed the lessons of the 1970s. Then, successive oil price shocks more than halved global growth and sent inflation into the double digits. It took a decade to bring inflation back under control, partly because central banks did not have the tools and knowledge they have now.
Experience shows that tightening policy quickly and decisively lowers the odds of a hard landing compared with moving slowly and gradually.
As policymakers struggle with urgent immediate challenges, they cannot lose sight of the big picture. For too long, fiscal and monetary policy have been the go-to economic fix, resulting in debt-fuelled growth. These have now run out of road.
Only structural reforms can reignite the drivers of long-term growth, including promoting competition, investing in public infrastructure and education and training for the digital age, and ensuring a durable and sustainable energy mix. As central banks grip the steering wheel and change course, other policymakers need to map out the route for the journey ahead.
*Agustín Carstens is General Manager of the Bank for International Settlements (BIS). The Basel, Switzerland-based BIS supports central banks' pursuit of monetary and financial stability through international cooperation, and acts as a bank for central banks.