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Inflation is a political challenge as well as an economic one

CTN News

 

The return of inflation is not just an important economic event. It is also a political one. As it becomes decreasingly plausible that it will simply fade painlessly away, tough decisions must be made on how to react to it.

This raises big issues. How did we get here? How large and durable a slowdown will be needed to bring inflation back under control? Is policy tight enough already? If not, what further steps might need to be taken? Not least, should inflation be brought down to previous targets or should policymakers give up and raise their targets instead?

Bar chart of Change in core and headline consumer price indices between May 2020 and May 2022 (%) showing The US and UK have seen the largest jumps in core prices over two years

The latest Annual Report of the Bank for International Settlements provides an excellent analysis of what is happening. More important, it illuminates the dangers in shifting away from the regime of low inflation of the past 40 years.

By April 2022, notes the BIS, “three quarters of economies were experiencing inflation above 5 per cent. Inflation was back, not as a long-sought friend, but as a threatening foe.” Indeed, inflation is by now both high and widely spread across countries and sectors. This was at first unexpected and then dismissed as transitory. Neither view has worn well. Inflation is also economically and politically salient. Quite simply, people care about it. Not least, unexpected inflation also means unexpected cuts in real incomes. Unsurprisingly, this is highly unpopular.

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The danger now is that of stagflation, defined as a prolonged episode of weak growth plus variable and persistent inflation. To help us understand the nature of this challenge better, the BIS explains the differences between a regime of low inflation and one of high inflation. It does so by looking “under the hood” at how inflation regimes actually work. Crucially, it turns out, inflation behaves differently in…

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