Introduction The recent remarkable surge in inflation after its long quiescence has raised pressing questions about the dynamics of inflat...
Introduction The recent remarkable surge in inflation after its long quiescence has raised pressing questions about the dynamics of inflation more generally. In the process, it has put the spotlight on the importance of sector-specific developments including the persistent pandemic-induced shift from services to goods; sectoral bottlenecks in global value chains; and soaring food and energy prices (see Chapter I).
An urgent question is whether higher inflation will become entrenched. These developments have underscored the need to go beyond the aggregate dynamics of inflation in order to shed further light on how its engine works, ie to look “under the hood”. What does this mean, concretely? Many workhorse models of inflation build on a Phillips curve relationship between inflation and economic activity. Taking this approach, inflation fluctuations reflect aggregate demand pressures on productive capacity, temporary supply shocks and changes in inflation expectations. Looking under the hood complements this perspective. It distinguishes clearly between a multitude of relative price changes and underlying inflation itself. It examines in detail how, and under which conditions, such relative price changes can morph into broader-based inflation. And it pays close attention to the wage-price formation process – the core of the inflation engine – illuminating how this depends on the rate of inflation itself and how it is linked to inflation perceptions and expectations.
This also means going beyond the well known cyclical drivers of inflation to examine the structural influences on wage- and price-setting. These are often global in nature. The distinction between relative price changes and underlying inflation is critical. Relative price changes reflect those in individual items, all else equal. This may or may not be related to underlying inflation, ie a broader-based and largely synchronous increase in the prices of goods and services that erodes the value of money and devalues the “unit of account” over time. Key takeaways • To better understand inflation, it is key to go beyond aggregate analysis in order to separate relative from generalised price changes and examine their joint dynamics. • Periods of high and low inflation are very different, notably with respect to their self-stabilising properties and how firms and workers respond to relative price shifts. • Preserving a low inflation environment is paramount and requires ensuring that relative price changes do not translate into entrenched inflation. Transitions from low- to high-inflation regimes are especially challenging because they tend to be self-reinforcing.
• Monetary policy has an essential role to play in ensuring the durability of a low-inflation regime through the features of its operating framework as well as through flexible and timely adjustments in the policy stance. 42 BIS Annual Economic Report 2022 Looking under the hood reveals some important features of the inflation process. Low-inflation regimes turn out to be very different from high-inflation ones.1 When inflation settles at a low level, it mainly reflects changes in sector-specific prices and exhibits certain self-equilibrating properties. Changes in inflation become less sensitive to relative price shocks, and wage and price dynamics are less closely linked. Moreover, there is evidence that the impact of changes in the monetary policy stance becomes less powerful. Transitions from low- to high-inflation regimes tend to be self-reinforcing. As inflation rises, it naturally becomes more of a focal point for agents and induces behavioural changes that tend to entrench it, notably by influencing wage and price dynamics. This puts a premium on better understanding how transitions work in order to be able to identify them early enough as events unfold. The transition from a low- to a high-inflation regime in the late 1960s and early 1970s illustrates some of the possible forces at play. These include large and persistent relative price increases – notably oil – in a context of strong cyclical demand and in an environment structurally conducive to wage-price spirals, ie high pricing power of labour and firms coupled with the loss of the monetary anchor provided by the Bretton Woods system. Monetary policy plays a key role in establishing and hardwiring a low-inflation regime and in avoiding transitions to a high-inflation one. Once a low-inflation regime is established, monetary policy can afford to be more flexible and tolerate more persistent, if moderate, deviations of inflation from targets. Having gained precious credibility, it can reap the benefits. At the same time, monetary policy must ensure that the regime is not jeopardised.
It is one thing to tolerate moderate deviations from point targets; it is quite another to put the system’s self-equilibrating properties to the test. The costs of bringing inflation back under control can be very high. Calibrating policy to prevent transitions is especially challenging. This chapter examines inflation in depth, from an under the hood perspective. It starts by defining inflation and characterising its behaviour as a function of its level, drawing on the disaggregated price data that underpin it. It then provides a systematic analysis of wage- and price-setting behaviour and of how changes in relative prices can give rise to inflation, facilitating transitions across regimes. Finally, it explores the key role of monetary policy in securing a low-inflation regime and preventing transitions to a high-inflation one.
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