The Future of Inflation Part I: Will Inflation Remain High?

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Authors: RUCHIR AGARWAL, MILES KIMBALL
Published: April 12, 2022

Summary of the current inflation episode

As of early 2022, both headline inflation and core inflation were significantly above target in most advanced economies and several emerging markets.
Five key drivers identified for the current inflation surge:
- Supply chain bottlenecks: pandemic-related disruptions and later demand-driven bottlenecks. Flexport Ocean Timeliness Indicator for Asia–North America and Asia–Europe routes remained close to all-time highs as of the end of February 2022.
- Shift in demand toward goods and away from services: durable goods (including used cars) saw large near-term inflation; part of the demand shift may persist due to longer-term changes like more work from home.
- Aggregate stimulus and post-pandemic recovery: about $16.9 trillion in fiscal measures announced globally; $1.9 trillion fiscal stimulus in the United States (the American Rescue Plan). Households ran down savings, fueling aggregate demand.
- Shock to labor supply: labor force participation remains below pre-pandemic levels in several countries; in the United States participation is about 1.5 percent lower (about 4 million fewer workers).
- Supply shocks from the Russian invasion of Ukraine (February 24, 2022): sharp rises in energy and food prices; wheat prices at record highs—Ukraine and Russia account for 30 percent of global wheat exports. Food and energy share of consumption can be as high as 50 percent in Africa.

Analytical framework and empirical findings

The five effects are summarized using AS-AD curves, distinguishing goods and services markets:
- Supply chain bottlenecks bind on the steep portion of the short-term supply curve in goods.
- Preference shift: AD rightward in goods, AD leftward in services.
- Fiscal stimulus: AD rightward in both goods and services.
- Labor supply shock and commodity/food price shocks: AS leftward in both markets.
- Result: initial modest increase in service prices but larger increase in goods prices (which may be reversing).
Cross-country pattern: inflation has risen almost everywhere; key uncertainties are duration of labor market tightness, persistence of supply chain bottlenecks, and central bank responses.

Central bank behavior and historical evidence

Historical context:
- Pre-late 1970s central banks were more tolerant of inflation; disinflation under Margaret Thatcher and Paul Volcker led to an institutional shift toward central bank independence.
- Many countries adopted similar strategies and institutional reforms, reducing inflation by the mid-1980s.
Empirical definitions used:
- “Having brought inflation under control” = a three-year stretch of quarterly inflation remaining below 4 percent since 1990. The first month in which this is achieved is termed the Blue Chip Month.
- “Surge of out-of-control inflation” = a 36-month period of inflation above 4 percent.
Findings for OECD countries:
- Chart 3 (described) shows Blue Chip Month for each OECD country; only Turkey had not achieved Blue Chip status to date.
- Once a central bank earns a Blue Chip, it rarely returns to out-of-control persistent inflation, except following mammoth financial crises (examples noted: Iceland and the Baltic states during the global financial crisis).
Central bank preferences and reaction functions:
- Central banks tend to dislike inflation; frequency of calls to raise the inflation target is relatively low.
- Reaction functions in advanced economies have a disinflationary bias, especially because many central banks act as if constrained by an effective lower bound on interest rates.
- The zero lower bound leads to asymmetric responses around the 2 percent target: tolerance for inflation below 2 percent and strong perceived welfare costs of inflation above 2 percent, helping to entrench low inflation expectations.

Scenarios and risks going forward

Main determinants of inflation beyond 2025:
- How determined central banks are to rein in inflation.
- Bond market confidence that governments will repay debts without inflating them away.
Ways the optimistic assessment could be wrong:
- Central banks’ dislike for inflation may be suppressed by long-term pandemic impacts, uncertainty about recovery, and temptation to inflate away higher debt burdens.
- Current central bank plans (dot plots or equivalents) may be behind the curve; Standard Taylor Rule calculations suggest it could easily take interest rates as high as 7 percent in several countries to bring inflation down.
- Fiscal–monetary interaction risk (John Cochrane’s argument): using higher interest rates to control inflation while keeping fiscal policy loose is analogous to accelerating and braking at the same time—if debt holders lose confidence in government willingness to repay without inflation, inflation could worsen.
- This scenario depends on (1) debt holders’ marginal propensity to spend rising when confidence falls and (2) government marginal propensity to cut other spending declining when interest expenses rise.
- Conversely, higher interest rates could avoid contributing to inflation instability if they reduce non-interest government spending more than they raise spending by government debt holders.

Policy implications and open questions

Central bank actions are crucial: history suggests an out-of-control surge beyond a couple of years is unlikely unless central banks abandon their anti-inflation preferences or a major crisis intervenes.
Key policy-relevant uncertainties:
- Duration of labor market tightness and supply chain bottlenecks.
- The duration of the War in Ukraine and its ongoing impact on energy, food prices, and global growth.
- Whether central banks’ reaction functions have changed post-pandemic.
- Interaction between fiscal policy, debt dynamics, and monetary policy credibility.

F&D Magazine article by RUCHIR AGARWAL and MILES KIMBALL; published on April 7, 2022.