Structural Factors and Central Bank Credibility Limit Inflation Risks

IMF Blog, February 19, 2021

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Global economy estimated at -3.5 percent at the end of last year.
Inflation was below target in 84 percent of countries at the end of last year.
The U.S. plan for an additional $1.9 trillion of fiscal spending has raised concerns about overheating, but historical evidence over the last four decades makes a persistent surge in U.S. inflation above the Fed’s 2 percent target unlikely.
U.S. unemployment rate swings: 10 percent in 2009 and 3.5 percent in 2019, yet inflation remained remarkably stable.
Preliminary IMF estimate: the proposed U.S. package, equivalent to 9 percent of GDP, would increase U.S. GDP by a cumulative 5-6 percent over three years.
Inflation, as measured by the Fed’s preferred index, would reach around 2.25 percent in 2022.

Globalization:
- Has limited inflation in traded goods and some services.
- Despite early disruptions, global supply chains have shown resilience and agility.
- Merchandise trade has recovered in lockstep with the recovery in manufacturing, surpassing pre-pandemic levels.
Slack in the global economy:
- Considerable slack remains, with over 150 countries projected to have lower per capita incomes in 2021 relative to 2019.
Automation and relative price trends:
- Automation and relative declines in the price of capital goods have largely kept higher wages from being passed through to prices.
- The crisis is likely to accelerate automation trends.
Market concentration and profit margins:
- Dominance of firms with high profit margins has allowed absorption of higher costs without raising prices (example: after the increase in U.S. tariffs).
- The crisis could increase the market share of such high-margin firms, as smaller firms have been harder hit.

Inflation expectations have remained broadly stable around central bank targets, supported by independence and credibility of monetary policy.
Credibility has reduced expectations that monetary policy will be used to keep government borrowing costs low at the expense of higher inflation.
Japan example: government debt averaged over 200 percent of GDP since 2009, yet inflation averaged just 0.3 percent over the past decade; the challenge has been to raise inflation expectations.

Fiscal policy targeting:
- Well targeted public spending would deliver similar improvements in employment and output with much smaller accumulation of debt, preserving space for future high social return spending.
- High quality public investment should raise potential output, increase demand, and be central to a comprehensive climate mitigation strategy.
Caution on historical extrapolation:
- Exceptional policy measures in 2020 included fiscal spending by G7 countries of 14 percent of GDP—well above the cumulative 4 percent of GDP spent during the financial crisis years of 2008–10.
- As a result, household savings rates in advanced economies are at multi-year highs and bankruptcies are 25 percent lower than before this pandemic.
- Pent-up demand as vaccines spread could trigger strong recoveries and defy inflation projections based on recent decades; conversely, delayed bankruptcies could later dampen confidence, weaken inflation, and lead to further job losses.
Central bank communication and pre-emptive action:
- Central banks should pre-empt the possibility of sharp swings in borrowing costs via early and clear communications of their intentions to avoid market turbulence.

Upside inflation risk: strong recovery and pent-up demand as vaccine protection becomes widespread could push inflation above recent trends.
Downside inflation risk: delayed bankruptcies and weakened confidence could dampen demand and reduce inflation, leading to further job losses.
Market turbulence risk: discovery of new virus variants, transitory swings in inflation, or earlier-than-expected rate increases by major central banks could tighten global financing conditions unexpectedly.

Source: IMF Blog post by Gita Gopinath, February 19, 2021.

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