## Inflation Scares

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**Canonical URL:** [Inflation Scares](https://www.imf.org/-/media/files/oap/oap-home/2021/oct2021-weo-chapter2.pdf)

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- [Markdown version](/-/media/files/oap/oap-home/2021/oct2021-weo-chapter2.pdf.md)
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### Rising inflation and proximate drivers
- The World Economic Outlook Chapter 2 documents rising consumer price inflation since the beginning of 2021, with headline and core CPI increases across AEs, EMs, and LIDCs.
- Drivers highlighted:
  - Firming demand, rising commodity price pressures, and supply chain disruptions.
  - Commodity price indexation shown with June 2014 = 100 for metals, oil, and food.
  - Household "cumulative excess savings" from 2020:Q1–21:Q1 measured relative to a 2017:Q1–19:Q4 linear trend.
  - Supply chain disruptions measured as the difference between the PMI supply delivery times subindex and a counterfactual cyclical measure based on the manufacturing output subindex.

### Evidence from the Phillips curve and slack–inflation link
- Empirical specification estimated for 31 AEs and18 EMDEs:
  - πi,t = β1 πi,t^e + β2 πi,t−1 + β3 y_i,t^dom + β4 y_i,t^for + β5 z_i,t + FE + εi,t (as presented in the chapter).
- Key estimates and findings:
  - A 1-percentage-point widening of the unemployment gap is associated with a decline in core inflation of 0.22 percentage point, on average.
  - Unprecedented pandemic disturbances do not seem to have altered the Phillips curve relationship for AEs; estimates for EMDEs are more sensitive to inclusion of the pandemic period.
  - A causal TSLS approach and other identification strategies are discussed to address biases (e.g., using narrative-based monetary policy shocks, treatment effects approach, policy propensity score weighting).
  - Confirmatory estimate: Phillips curve slope of -0.22 for AEs.

### Contribution of recoveries to inflation dynamics
- Using the Phillips Curve to back out contributions from closing the unemployment gap:
  - Recoveries induce a moderately positive inflation impulse in 2021 and 2022.
  - The impact softens in 2023 and 2024 and turns into a negligible disinflation impulse in 2026.
  - Aggregate outcomes mask heterogeneity; the United States and its policy support drive short-term dynamics.
  - For EMs, recovering labor markets produce a stronger inflation impulse initially, but contributions remain moderate through the forecast horizon.

### Inflation expectations and anchoring
- Historical analysis:
  - 55 episodes of "inflation accelerations or scares" identified.
  - Such episodes are associated with large exchange rate depreciations and, in EMs, upsurges in fiscal and current account deficits.
  - More persistent episodes feature steeper rises in three-year-ahead inflation expectations.
- Market-based measures:
  - Long-term expectations proxied by the 5 year 5-year forward break-even rate.
  - Local projection regressions on a sample of 14 countries use oil price shocks, NEER, and VIX among controls.
  - Results indicate a small effect of oil price shocks on long-term expectations and no significant change in the relationship during the pandemic.
  - No evidence of de-anchoring in response to the exceptionally large policy responses to the pandemic so far.
- Tail-risk scenario considered:
  - An extreme de-anchoring shock assumes inflation expectations become adaptive (no longer forward-looking but react to incoming data) for a period of 12 months.
  - In that scenario, inflation increases substantially and becomes more persistent and volatile.

### Sectoral and commodity price dynamics
- Sectoral price dispersion during the pandemic is assessed as not exceptional by historical standards.
- Sectoral price dynamics so far suggest moderate risks to the inflation outlook.
- Continued sectoral and commodity price shocks would push up headline inflation; however, even extreme sectoral disruptions have only short-lived effects on the inflation outlook according to the analysis.

### Baseline inflation outlook and risk scenarios
- Baseline forecast:
  - Headline inflation expected to revert to pre-pandemic levels by mid-2022.
  - Long-term inflation expectations present a relatively strong degree of anchoring.
  - Balance of risks tilted to the upside over the medium term.
- Adverse sectoral and commodity price shock scenario:
  - Headline inflation would increase significantly, peaking at 4.4 percent, on average, in AEs by mid-2022 and 8.4 percent in EMs by early 2022.
  - Risks broadly balanced over the medium term; inflation expectations strongly anchored in AEs but overshooting of expectations in EMDEs in the short-term.

### Main findings (summary bullets)
- A significant relationship between slack and inflation remains.
- Inflation expectations have remained relatively anchored to date.
- Sectoral price dynamics suggest moderate risks to the inflation outlook.
- Sectoral price dispersion during the pandemic is not exceptional historically.
- Inflation forecasts show a sharp near-term rise in inflation.
- Continued sectoral and commodity price shocks would raise headline inflation, though extreme sectoral disruptions have only short-lived effects on the outlook.

### Policy implications and recommendations
- Central banks face a tightrope: carefully balance responsiveness to rising near-term inflation with preserving long-run anchoring of expectations.
- Use clear and state-contingent forward guidance and communication, with well-articulated triggers for action.
- Maintaining strong fiscal credibility is important for inflation anchoring.
- Acknowledge high uncertainty about medium-term output gaps.

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_Source: https://www.imf.org/-/media/files/oap/oap-home/2021/oct2021-weo-chapter2.pdf_