By Professor Sir Anton Muscatelli, PhD, FRSE, University of Glasgow — The Conversation, 14 December 2021
Central banks are being tested by the recent resurgence in inflation, with The US recently reporting an annual rate of inflation of 6.8%, the highest in nearly 40 years. The key question they are asking is whether this inflation is temporary (“transitory”) or persistent. If it is only transitory, it would be counterproductive to deal with it aggressively. If central banks tighten monetary policy unnecessarily by sharply raising short-term interest rates or quickly unwinding their government asset purchases (quantitative easing or QE), it will needlessly push back the recovery.
Today’s inflation is due primarily to the disruption the pandemic has caused to key global supply chains. In sectors like electronic goods and vehicle production, bottlenecks and shortages of key inputs such as semiconductors emerged as consumer demand recovered more rapidly than suppliers could keep up with. Shortages of shipping containers and freight capacity have increased costs. The rapid economic recovery in 2021 has also put pressure on energy prices, especially spot gas prices in Europe. Meanwhile, labour shortages are a factor: the UK and US are among those nations seeing labour-force participation fall due to people retiring.
For central banks, the key question relates to inflation expectations. If consumers and businesses believe that inflation will continue at similarly high levels, as they did in the 1970s, they will try to incorporate it into wage claims and in setting future prices, making inflation more persistent. There is some evidence that inflation expectations in the US, eurozone and UK have increased marginally in the latter half of 2021, but they still seem contained. One difference with the 1970s is that labour markets are more flexible, with trade unions having less wage-bargaining power in the private sector and greater international competition due to globalisation.
If data by early to mid-2022 shows inflation dissipating, central banks might only need to increase rates gradually. But if inflation remains stubbornly higher than targets for a longer time-horizon, it would be evidence that a wage-price spiral has set in, and central banks would then have no alternative but to substantially increase short-term interest rates and reduce QE — potentially causing recessions as seen in the 1970s and early 1980s. This article has been republished under Creative Commons licence.