High inflation is probably transitory, and central banks should tell people that… but totally be ready in case they aren’t. That’s the take from the IMF today, who released its latest global outlook. The agency said high inflation should ease, and central banks should communicate that message. However, it may not be transitory, and monetary authorities should be ready to act if it’s not.
The Pandemic Provided The Perfect Environment For High Inflation To Soar
This isn’t groundbreaking for anyone that’s had to buy anything recently, but the price of goods is climbing. A lot. The pandemic provided a perfect combination of restricted supply, and stimulus for demand. Supply restrictions came in the form of reduced production to accommodate health measures. Tight transport also made shipping goods cost-prohibitive.
Stimulus demand largely came in the form of low interest rates, and the wealth effect. Low interest rates cause budgets to rapidly expand, helping to provide cheap capital. When the price of assets rises, people engage in a “wealth effect.” This means they spend more because they feel rich.
The combination has pushed global inflation readings higher. Canada’s consumer price index (CPI) is currently reading 3.6% higher than a year before. US CPI came in even higher, showing annual growth of 5.4% at the last measure. This is the highest rate both countries have experienced in a very long time. Naturally, people are starting to worry about how high this can get over the next few years.
High Inflation Is Expected To Be “Transitory,” aka Temporary
The official take is that inflation expectations are just a transitory issue. Prices should come back down to reality over the next few months. “Inflation is expected to return to its pre-pandemic ranges in most countries in 2022 once these disturbances work their way through prices, though uncertainty remains high,” said the IMF
As the economy reopens and the effect of low interest rates wears thin, prices should pull back. We’ve begun to see some signs of that, with lumber as a good example. Prices surged 10x its pre-pandemic price, but have since fallen over 60% lower from their peak. And that’s the problem in a nutshell. Both takes are correct. High inflation is proving to be transitory, but is significantly higher than normal. After all, a 60% drop after a 10x increase is still a lot higher than it started.
IMF Warns Central Banks To Be Prepared If Inflation Isn’t Transitory
The IMF warned central banks not to act too hastily, and wait for more clarity. “Central banks should generally look through transitory inflation pressures and avoid tightening until there is more clarity on underlying price dynamics,” said the agency.
In the meantime, they suggest central banks communicate the expectations of high inflation. Higher inflation expectations tend to play a role in shaping future expectations.
“Clear communication from central banks on the outlook for monetary policy will be key to shaping inflation expectations and safeguarding against premature tightening of financial stimulus conditions.”
They do, however, warn central banks to be on high alert these days. In the event inflation doesn’t taper as expected, central banks need to be able to stop stimulus. This could include ending quantitative ease (QE) programs, as New Zealand recently did. In a more extreme situation it could mean hiking the overnight rate and reducing liquidity.
“There is, however, a risk that transitory pressures could become more persistent and central banks may need to take preemptive action,” said the agency.
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