After reaching its highest level in decades in mid-2022, inflation in the US and the eurozone fell sharply over the second half of last year. But, in December, the headline consumer price index (CPI) in the US and the Harmonized Index of Consumer Prices (HICP) in the eurozone rose slightly. Was it an aftershock or a foreshock?
Central banks, taken aback by last year’s rapid disinflation, now face the question: Are their calls for caution driven by a belief in persistent inflationary pressures, possibly explaining recent increases, or are they simply admitting uncertainty?
Markets seem to be embracing the latter explanation, anticipating that the US Federal Reserve and the European Central Bank will start cutting interest rates in the spring. This sentiment is not unfounded: If we consider the six-month annual percentage change in core inflation — a timelier indicator of underlying inflation than the 12-month change — the US and the eurozone have brought inflation back to their 2% target. The evidence points to a persistent decline, regardless of the recent (small) increase in headline figures.
This means that price stability may well have been re-established within three years, which by most definitions would make the latest bout of inflation “transitory.”
But let us not get caught up in the rather pedantic debate between those who argued that inflation would be short-lived and those who anticipated it would be “persistent.” Instead, we should seek to understand the mechanisms that pushed inflation up and then down to draw lessons for responding to future price volatility.
Monetary policy is a powerful tool; it can always bring inflation down eventually. Central banks are often encouraged to get to work right away: If they do not intervene quickly and firmly, the logic goes, inflation expectations might become “unanchored,” fueling a wage-price spiral that leads to employment losses. This was the story of the 1970s.
See also: BOK surprises with rate cut as Trump win boosts trade risks
Aggressive disinflation has drawbacks as it can harm economic growth and the financial sector’s performance. The details depend partly on the factors driving inflation: If the culprit is an uneven supply shock (associated with large relative price changes), the costs of disinflation are likely to be higher than if the cause is a surge in aggregate demand.
Fiscal policy action
The recent inflation surge in the eurozone was primarily caused by uneven energy and supply shocks, gradually affecting economic sectors, starting with manufacturing and then extending to services. This trend is likely observed in the US, albeit to a lesser extent.
In both economies, pressure from wage “catch-up” was modest — there was no sign of a wage-price spiral. During the disinflationary phase, the US or Europe’s labour market has not weakened significantly. In other words, both inflation and disinflation have played out in goods markets, not labour markets.
See also: ECB’s Schnabel sees only limited room for further rate cuts
Despite core inflation initially lagging behind headline inflation’s decline, it is now converging toward the 2% target. This notable drop happened before economic activity weakened, possibly due to monetary tightening.
According to Eurostat, the quarterly GDP growth in Germany was zero in the second and third quarters of 2023 and is now estimated to have fallen to –0.3%. The euro area average has fared slightly better, with no growth in the fourth quarter after –0.1% in the third. An ECB bank lending survey found that demand for bank loans is weaker than during the 2011 sovereign debt crisis.
Expect more frequent inflation spikes due to significant shifts in relative prices. For starters, an energy transition is underway, so increases in energy demand may well run up against supply constraints, which are even more likely amid rising geopolitical tensions — the recent attacks by Houthi rebels on ships in the Red Sea may offer a glimpse of what is to come.
Given the complex circumstances, traditional inflation targeting may fall short. Central banks should contemplate allowing more time to address inflation amid uneven supply shocks. Aggressive monetary tightening, the typical remedy, is less effective against supply-side shocks and brings significant costs. This includes jeopardising financial stability and hindering efficient resource allocation. Prolonged tight monetary conditions might discourage long-term investments, like those in green technology.
When supply constraints drive inflation, monetary tightening alone is not the answer. Fiscal policy action — and monetary and fiscal coordination — will also be needed. We are not living in the 1970s or the 1990s. How we think about inflation must apply the lessons of experience (including from the recent past) to current price conditions and, on that basis, attempt to anticipate the future. — © Project Syndicate, 2024
Lucrezia Reichlin, a former director of research at the European Central Bank, is a Professor of Economics at the London Business School
