“Shock” inflation requires high rates

The rapid reversal of inflation expectations in the face of sharp price shocks may explain a larger rise in core inflation than “pre-pandemic” economic models predicted, according to a paper by IMF economists Jorge Alvarez and Allan Disioli. Because of the shock, consumers are remembering past episodes of rising prices, which gives a shift in expectations – so the monetary authorities should raise rates faster to prevent “anchoring” expectations at new levels. At the same time, their bursts may not be accompanied by a pronounced increase in unemployment, which reduces the overall costs of returning inflation to target levels.

After the financial crisis of 2008–2009, economists began to view inflation as consistently low and inflation expectations as “anchored”. This perception has become the norm in many countries — but the post-pandemic shock caused by a sharp recovery in consumer activity amid logistics disruptions has led to a change in the so-called Phillips curve (showing an inverse relationship between inflation and unemployment) and a shift in inflation expectations, economists at the International Monetary Fund (IMF) point out. ) Jorge Alvarez and Allan Disioli.

Projections in models with a flatter Phillips curve (when a slight decrease in inflation corresponds to a stronger increase in unemployment) failed to predict the current increase in core inflation (according to the IMF, most countries have not yet peaked, despite a slowdown in overall energy price growth and food). According to the authors, this indicates a change in the curve itself: it has become steeper, because reflects changes in expectations against the background of a price shock: economic agents do not behave quite “rationally” (from the point of view of the model), taking into account the experience of past episodes of price growth when adapting to a new reality – and the farther inflation is from the target, the stronger expectations affect its final index. Anchored expectations, on the other hand, follow a flatter curve (which is more common in developed economies—household expectations in Mexico are twice as strongly tied to past inflation experiences than in the US).

In shock periods (including due to the global rise in the cost of raw materials and supply chain disruptions), with a sharp shift in expectations, the acceleration of inflation may not be accompanied by a pronounced change in the unemployment rate. Accordingly, the costs of fighting inflation by raising rates by central banks in such cases may ultimately turn out to be lower than those calculated in models that are relevant in “normal” times. Therefore, the authors consider a more rapid and more pronounced increase in rates by regulators in response to shocks, with a possible stronger easing of policy in the future, justified.

The observation, however, is not applicable to external shocks in developing countries – in them, with a strong weakening of the national currency, the Philips curve can become even flatter, and the costs of fighting inflation are higher than calculated (as an example, two shocks in Brazil are given – in 2003 and 2015). ). Internal shocks (for example, the release of fuel prices in Mexico in 2017), as well as in general at work, lead to a steeper curve. For the US, the authors’ model predicts continued inflation, which is 1.5 percentage points above previous levels even 12 quarters after the shock began. The latest comments by Fed Chairman Jerome Powell also indicate the readiness of the regulator to further raise the rate – probably before signs of a downturn in the labor market appear, which, as follows from the authors’ model, are not showing them yet, despite rising inflation.

Tatyana Edovina