Inflation Scares in an Uncharted Recovery

IMF Blog, October 6, 2021

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Authors: Francesca Caselli, Prachi Mishra
Date: October 6, 2021
The economic recovery has fueled a rapid acceleration in inflation in 2021 for advanced and emerging market economies, driven by firming demand, supply shortages, and rapidly rising commodity prices.
The World Economic Outlook forecast cited expects higher inflation to continue in coming months before returning to pre-pandemic levels by mid-2022, though risks of an acceleration remain.

Headline consumer price index inflation has been examined relative to unemployment; despite pandemic-related challenges, the unprecedented disturbance doesn’t seem to have substantially altered this relationship.
Advanced economies:
- Likely to face moderate near-term inflation pressure, with the impact softening over time.
Emerging markets:
- Estimates of the relationship between slack and inflation appear more sensitive to the inclusion of the pandemic period in the estimation sample.

Measures of long-term expectations (breakevens drawn from government bonds in 14 nations) have been stable during both the crisis and the recovery.
Key risk question: what combination of conditions could cause a persistent spike in inflation, including expectations becoming unanchored and sparking a self-fulfilling upward spiral?
Historical associations with de-anchoring episodes:
- Sharp exchange-rate depreciations in emerging markets.
- Surging fiscal and current account deficits.
Other contributing factors to possible de-anchoring:
- Longer-term government spending commitments.
- External shocks.
- Central banks perceived as unable or unwilling to contain inflation.
- Prolonged overshoot of an inflation target can itself cause de-anchoring.

The pandemic triggered large price movements in food, transportation, clothing, and communications.
Despite sectoral price moves, dispersion (variability) in prices across sectors has remained relatively subdued by recent historical standards, especially compared with the global financial crisis.
Reason cited: relatively smaller and shorter-lived swings in fuel, food, and housing prices post the pandemic — these are the three largest components of consumption baskets, on average.

Advanced economies:
- Annual inflation will peak at 3.6 percent on average in the final months of this year before reverting in the first half of 2022 to 2 percent, in line with central bank targets.
Emerging markets:
- Inflation reaching 6.8 percent on average then easing to 4 percent.
Food prices:
- Food prices around the world jumped by about 40 percent during the pandemic, posing an acute challenge for low-income countries where food purchases make up a big share of consumer spending.
Uncertainty and upside risks:
- Inflation may be elevated for longer due to surging housing costs, prolonged supply shortages, food-price pressure, and currency depreciations in emerging markets.
Simulations:
- Several extreme risk scenarios show prices could rise significantly faster on continued supply chain disruptions, large commodity price swings, and a de-anchoring of expectations.

Central bank policy credibility and price expectations are difficult to precisely define; anchoring assessments cannot rely solely on historical data relationships.
Policymakers must:
- Walk a fine line between remaining patient in supporting the recovery and being ready to act quickly.
- Establish sound monetary frameworks, including triggers for when they would reduce support to rein in unwelcome inflation.
Possible thresholds for action include early signs of de-anchoring inflation expectations, such as:
- Forward-looking surveys indicating de-anchoring.
- Unsustainable fiscal and current account balances.
- Sharp currency swings.
Historical lessons:
- Strong policy action has often tamed inflation and expectations.
- Sound and credible central bank communication played an especially crucial role in anchoring views.
Authorities should be alert to combinations of individually benign risks that together could produce a “perfect storm” of price pressures, leading to significantly more rapid increases than IMF forecasts predict.

Source: IMF blog — “Inflation Scares in an Uncharted Recovery,” Francesca Caselli and Prachi Mishra, October 6, 2021.