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.
59 Comments
It's nothing to do with Orr. This is completely out of the control of finance folk, of any hue.
"Only structural reforms can reignite the drivers of long-term growth"
Bollocks - only an infinite planet could do that.
They all - like GBH who reminds me so much of Wolly and who seems to have learned a new language... - miss the point now. The G7 miss the point (or avoid it); Putin addresses it and the Brics are aware. They are more aligned with the inevitable trajectory, than we US sattelites.
By backing a new currency based on a basket of commodities. Putin understands the US fiat reserve currency is worthless. Sanctions will only accelerate USA's demise. The US now has to play by Putin's rules, Russia has the energy and the resources to make that happen.
Adrian Orr and interest rates don't affect shipping rates and commodity prices, despite the loud cries of frustrated monetary hawks.We have a price shock, more than an inflation problem, and interest rate increases which plunge the economy into recession won't help. More government fiscal restraint would help, but mostly, we need to let this thing play out. That requires a bit of patience, not trying to lead central bank interest rate rises. Not easy for Orr, when government are deflecting blame for inflation to RBNZ.
Robertson on 1News told me that the NZ economy is resilient. New Zealand is both COVID free and recession free. Best place to live in the world.
Agree.
I'd say we're already in the zone, maybe with another 50bp increase, and fixed rate rolls and fuel price increases are going to soak up most consumer capacity without it.
Significant further rate increases will plunge us into a recession with most impact on the embattled under 40s - with their student loans, paying too much in rent or mortgaged to the eyeballs and with young families.
All will fine for deposit holding baby boomers and other beneficiaries, but people looking after their own future will be hammered again - as they have been with low interest rate induced house price increases.
Agree.
I'd say we're already in the zone, maybe with another 50bp increase, and fixed rate rolls and fuel price increases are going to soak up most consumer capacity without it.
Significant further rate increases will plunge us into a recession with most impact on the embattled under 40s - with their student loans, paying too much in rent or mortgaged to the eyeballs and with young families.
All will fine for deposit holding baby boomers and other beneficiaries, but people looking after their own future will be hammered again - as they have been with low interest rate induced house price increases.
In the 70ies, the debt was allowed first to devalue via inflation over several years, only then were interest rates hiked.
Now, with our overindebted economy, aggressive rate hikes will cause economic depression. The more I read, the more I have the impression that this is precisely the goal.
Its being felt anywhere there's been a significant urbanisation, including developing world.
As for your question, hard to say, there doesn't look to be a clear drop in birthrate directly correlating with reduced housing affordability. Germany and Japan, two of the lowest birthrates, don't have the same level of housing affordability problems as say, here or Canada.
You Keynesians just do not get it. Interest rates should be above the inflation rate. That will stop inflation in its tracks. The unseen enemy is the government and central bank printing presses, demographics (not favorable for the western world) will take years to have any effect, as we will lose our young to the hermit kingdom totalitarianism.
Much of modern macroeconomics presupposes that lowering interest rates has a positive effect on economic growth (Lilley & Rogoff, 2019; Rogoff, 2017). Despite the pervasiveness of the idea that interest rates and growth are inversely related and there is some causality from rates to growth, economic theory has never delivered a convincing argument why the microeconomic negative relationship between rates and investment must survive the problem of aggregation. Our empirical findings reject the theoretical argument that interest rates affect economic growth causally, and in an inverse manner.
On balance, our empirical results show that (1) the correlation between economic growth and interest rates is not negative but positive in virtually all countries examined over most time periods, and; (2) when significant, the majority of evidence suggests that the causal link does not run from interest rates to economic growth, but more likely from economic growth to interest rates; (3) the findings apply also to the period before the 2008 crisis. We believe these results hold for both industrialized and emerging market economies. This means that monetary policy confined to lowering or raising interest rates cannot be effective in moving the economy in the claimed direction, and that this could be a general result applying not just to a post-crisis situation. Link
The key sentence from the article seems to be. "The current combination of high inflation coupled with historically high debt levels is unprecedented". That means it has not happened before. So no one knows what will happen if we raise interest rates too aggressively in this situation. How aggressive is too aggressive? Is a recession necessary? Is a recession tolerable? Will not figuring out we are in recession early enough cause it to be worse than necessary and possibly trip us over to a depression?
Will the Fed pivot to restore confidence in all assets. Accept inflation at 4-6% for medium term and keep interest rates below neutral until some of the high debt levels can be inflated away.
Hey we have an overinflated housing market in NZ leading to all sorts of social and economic risks. Increasing the OCR will sort that out at last.
At the same time it will impact local inflation and spend directly (as people have less money) which is part of the puzzle. If we do that at the same time as all the other reserve banks in the west then we will all lower our local spend, everyones consumption (oil, food, luxury goods etc) drops (our asset bubbles deflate together) and we all have less NEED for imported products reducing the cost of everything we all import and thus stopping inflation. did i miss somwthing?
As stated prior - we all also need to follow the fed to ensure our exchange rate stays within surviveable limits, import inflation doesnt hike... and we can all afford to buy food and other imported stuff. so the OCR needs to rise for that too.
Reduced house prices are badly needed in NZ, as is the requirement to stop an overinvestment in property vs productive business... and recessions are also necessary to keep economies and prices from overcooking... like now and to kill of zombie businesses etc... Its a cycle that has gone on for 100 years or so and is part and parcel of our global economic system.
The only people that are likely worrying are overleveraged or who bought assets at a peak.. for them it is a short sharp (or drawn out) lesson in economics... which is part of the process . all will be good in 10 years again and they will have the benefit of history like us old timers.. we all learn somehow..
I agree with you - supply is the issue (there isnt as much to go round as there was... due to russia/ukraine - oil/food , china lockdowns)... however as we cant free up supply then we can only choke demand... i know for sure most people i know in the west eat too much, drink too much, use cars more than need, fly places more than needed, we have heating on more than we need, buy more new clothes and stuff than we need. we all do it.
Building material wise - honestly do we really need so many more houses and buildings if global birth rates are dropping? doesnt make sense. plus i wonder on a 'bedroom basis' in NZ... (and elsewhere) how many are actually used every day (how many garages and spare rooms and even houses sit empty).
So.. if (like the old days) we all have less money, then we learn to do more with it... when i grew up in the UK nobody had half the stuff/space/travel as we all now .. and it certainly wasnt a bad life. So i cant see the downside :) climate wise its a big plus too.
No demand is the issue. All that government spending and money printing pushed demand to record levels, to stimulate the economy when no one was working. Kiwis loaded up on unproductive toys, fixed their houses, bought some more worthless Chinese plastics and vacationed at their local resorts. Here in America store shelves are still loaded. Mmm.
More like a short sharp lesson in being born at the wrong time. I doubt it 'will be good' if many have swung from a rope or have nervous breakdowns from severe financial pressure caused by ever-increasing debt costs, and in ten years time they might be lucky if they're no longer underwater.
Total baloney. There is no evidence of a wage price spiral (wages are lagging way behind). There is plenty of evidence of high energy prices driving a broad range of price increases. It is simply MADNESS to think that central banks can slow economies down enough with monetary policy to bring oil prices down when the oil industry and OPEC are able to set any price they like (due in part to Russian oil being unavailable to many).
So why do these banking folk and economists keep pushing this line? Because their worse case scenario is workers getting enough power to increase wages (squeezing profits and shareholder / capital returns) - or maybe they are scared witless by economic policy being driven for the people by the people, rather than being driven by neoclassical economists and bankers working for big business and capital.
This article misses the point. There have been no "years of undershooting inflation targets". Instead, the inflation has occurred in the housing market.
Now, it is spilling over into consumer prices, whilst the housing market is sharply contracting. This is dangerous, it could lead to a great depression.
The fact that the official inflation rate ignores housing prices is ridiculous. It leads to a roller-coaster of 'rock-star economy' with artificially low interest rates, followed by economic depression with rising interest rates when the economy is in fact collapsing.
The solution, now that the debt bubble has been created, would be to allow consumer price inflation to run its course. The money that has been created at low interest rates cannot be taken back, much like a vaccination cannot be taken back once injected.
The time to consider the long term effects of both money printing and vaccinations is beforehand. Now, the best we can do is let inflation run its course.
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