The economic recovery has fueled a rapid acceleration in inflation this year for advanced and emerging market economies, driven by strengthening demand, supply shortages and rapidly rising commodity prices.

We forecast in our latest World Economic Outlook that the rise in inflation is likely to continue over the next few months before returning to pre-pandemic levels by mid-2022, although risks of acceleration remain .

The good news for policymakers is that long-term inflation expectations are well entrenched, but economists still disagree on the continued upward pressure on prices.

Some have said the government’s stimulus measures could lower unemployment rates enough to raise wages and overheat economies, which could undermine expectations and lead to a self-fulfilling inflation spiral. Others believe that the pressures will ultimately be transient as a one-time increase in spending wears off.

Inflation dynamics and demand recovery

We examine whether headline consumer price inflation has moved in line with unemployment. While the pandemic period poses many challenges in estimating this relationship, the unprecedented disruption does not appear to have significantly altered this relationship.

Advanced economies are expected to face moderate inflationary pressure in the short term, the impact of which will subside over time. Estimates of the relationship between soft, the amount of resources in an economy that are not being used and inflation for emerging markets rather seem to be more sensitive to the inclusion of the pandemic period in the estimation sample.

Anchoring expectations

Inflation during the pandemic has been well entrenched, according to measures of long-term expectations known as government bond breakevens in 14 countries. These closely watched indicators have remained stable so far during the crisis and the recovery, although uncertainty remains about the outlook.

A key question is what combination of conditions could cause a persistent spike in inflation, including the possibility that expectations may no longer be anchored and help trigger a self-fulfilling price spiral.

Such episodes in the past have been associated with large exchange rate depreciations in emerging markets and have often followed rising budget and current account deficits. Longer-term public spending commitments and external shocks could also help to de-anchor expectations, especially in economies where central banks are not expected to be able or willing to contain inflation.

Moreover, even when expectations are well anchored, a prolonged overshoot of the inflation target set by policy makers could lead to a de-anchoring of expectations.

Sector shocks

The pandemic has triggered significant price movements in some sectors, including food, transport, clothing and communications. Surprisingly, price dispersion or variability between sectors has so far remained relatively moderate by recent historical norms, especially in relation to the global financial crisis. This is because fluctuations in the prices of fuel, food and shelter are relatively smaller and of shorter duration after the pandemic, which are on average the three largest components of consumption baskets.

Our forecast is that annual inflation in advanced economies will peak at 3.6% on average in the latter months of this year before falling back in the first half of 2022 to 2%, in line with central bank targets. Emerging markets will see faster increases, reaching 6.8% on average, then declining to 4%.

There is considerable uncertainty in the projections, however, and inflation could be high for a longer period of time. Contributing factors could include soaring housing costs and prolonged supply shortages in advanced and developing economies, or pressure on food prices and currency depreciations in emerging markets.

World food prices have jumped by about 40 percent during the pandemic, a particularly acute challenge for low-income countries where these purchases represent a significant portion of consumer spending.

Simulations of several extreme risk scenarios show that prices could rise significantly faster in the event of continued supply chain disruptions, large swings in commodity prices, and a de-anchoring of expectations.

Political implications

When expectations are no longer anchored, inflation can take off quickly and it can be costly to keep it under control. Ultimately, the credibility of central bank policy and price expectations are difficult to define with precision, and any assessment of the peg cannot be decided entirely on the basis of the relationships in historical data.

Policymakers therefore need to distinguish between remaining patient in supporting the recovery and being ready to act quickly. More importantly, they need to establish strong monetary frameworks, including triggers for determining when they would reduce support to the economy in order to contain unwanted inflation.

These action thresholds could include early signs of unanchoring inflation expectations, including forward surveys, unsustainable budget and current account balances or sharp currency fluctuations.

Case studies show that while vigorous policy action has often brought inflation and expectations under control, strong and credible central bank communication has also played a particularly crucial role in anchoring opinions. Authorities need to be alert to the triggers of a perfect storm of price risk that could be individually benign but, when combined, can lead to increases much faster than projected in the IMF’s forecast.

Finally, a key feature of the outlook is that there are significant differences between different economies. Faster inflation in the United States, for example, should help accelerate advanced economies, although pressures in the eurozone and Japan are expected to remain relatively weak.

* About the authors:

  • Francesca Caselli is an economist in the World Economic Studies Division of the IMF’s Research Department
  • Prachi Mishra is an adviser in the IMF’s Research Department. Prior to joining the Fund, she worked at Goldman Sachs as Managing Director, Global Macro Research, and Chief Economist for India

Source: This article was published by IMF Blog

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