History's Inflation Lessons

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A study of 100 inflation shocks since the 1970s provides the basis for the analysis.
The article draws on IMF Working Paper 2023/190, “One Hundred Inflation Shocks: Seven Stylized Facts,” by Anil Ari, Carlos Mulas-Granados, Victor Mylonas, Lev Ratnovski, and Wei Zhao.
Contextual points from recent history:
- World inflation reached historic highs in 2022 after Russia’s invasion of Ukraine triggered a terms-of-trade shock akin to that of the 1970s.
- In advanced economies, prices rose at the fastest pace since 1984.
- In emerging market and developing economies, the price increase was the largest since the 1990s.
- Headline inflation in the United States and across much of Europe has halved from about 10 percent last year to less than 5 percent today.

Inflation persistence:
- It takes years to “resolve” inflation by reducing it to the rate that prevailed before the initial shock.
- 40 percent of countries in the study failed to resolve inflation shocks even after five years.
- It took the remaining 60 percent an average of three years to return inflation to pre-shock rates.
Patterns of premature easing:
- Nearly 30 countries in the sample (including Denmark, France, Greece, and the United States) loosened policy prematurely after the 1973 oil-price shock.
- 90 percent of countries that failed to resolve inflation saw price growth slow sharply in the first few years after an initial shock, only to accelerate again or become stuck at a faster pace.
Policy stance and outcomes:
- Countries that successfully resolved inflation tightened macroeconomic policies more in response to the inflation shock and maintained a tight policy stance consistently over a period of several years (examples include Italy and Japan after the 1979 oil-price shock).

Consistency and credibility:
- Maintain a tight policy stance consistently over several years rather than loosening policy after initial declines in inflation.
- Policy credibility matters: countries where inflation expectations were more firmly anchored, or where central banks had past success maintaining low and stable inflation, were more likely to defeat inflation.
Monetary–fiscal interaction:
- Central bankers are on the front line, but governments must not make the task harder by adding to price pressures with loose fiscal policy.
- To make fiscal support during a cost-of-living crisis less inflationary, governments should target relief to the most vulnerable.
Labor market focus:
- Remain focused on real wages, not nominal wages, when responding to developments in the labor market.
- Historically, countries that resolved inflation successfully tended to have lower nominal wage growth; this did not translate into lower real wages because lower nominal wage growth accompanied lower price growth.
- Watch for the risk that wage growth needed to catch up with past declines in real wages could fuel inflation or lead to wage-price spirals if too high.

Countries that resolved inflation successfully were better at maintaining external stability:
- Free-floating currencies were less likely to depreciate sharply.
- Currency pegs were more likely to survive.
This pattern reflects success in fighting inflation through tighter monetary policy and greater policy credibility, rather than a prescription for currency intervention.

Short-term vs. medium/long-term trade-offs:
- Historically, countries that resolved inflation had lower economic growth in the short term than those that did not.
- Five years after the inflation shock, countries that resolved inflation had higher growth and lower unemployment than economies that allowed inflation to linger.
Cumulative costs:
- Cumulative welfare losses from unresolved or permanently high inflation dominate over the medium to long term.
- Allowing inflation to linger leads to accumulating costs of macroeconomic instability and inefficiency.

Fighting inflation is a marathon, not a sprint:
- Policymakers must persevere, demonstrate policy credibility and consistency, and keep their eyes on returning inflation firmly to target.
- History suggests that inflation’s recent decline could be transitory; policymakers should avoid celebrating too soon.

History’s Inflation Lessons, ANIL ARI and LEV RATNOVSKI, F&D Magazine, December 2023.

F&D: History’s Inflation Lessons
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