Has inflation caught up?

Inflation is like sin; every government denounces it, but every government practices it.”

Georg Christoph Lichtenberg

Central banks and many forecasters may be underestimating the risk of persistently high inflation. Although inflation is likely to recede next year, the outlook is uncertain and its deceleration is expected to be very gradual. The longer inflation remains high, the more likely it is to fester.

With some signs of spillover, both from workers’ desire for higher wages and from companies setting prices and wages, the risk of a spiral of wages and prices seems to be increasing.

Inflation expectations have tended to increase significantly since the start of the pandemic, although to different degrees across countries.

There is a high probability that inflation will remain high, many people are unaware of the objectives of central banks or doubt their ability or that of their officials to meet their inflation objectives. What is more worrying is that to keep inflation low, the measures are painful and relatively limited.

The inflationary period of the 1970s is often attributed to a structural change in people’s perceptions and attitudes towards inflation. Former Fed Chair Janet Yellen describes the rise of an inflationary psychology in which rising inflation led people to revise their inflation expectations upwards, causing actual and expected inflation to rise over time and the transactions will adapt to it.

According to the University of Michigan Survey of Consumers, awareness of inflation in the United States is now higher than it was in the late 1970s.

In June, the president of the Federal Reserve Bank of St. Louis argued that “the current macroeconomic situation in the United States is testing the credibility of the Federal Reserve relative to its inflation target.” This is confirmed by the evidence on the degree of anchoring of inflation expectations.

Expectations have deviated substantially from the Fed’s target, and are well above the target, particularly among households and businesses. To varying degrees across countries, the deviation from the target has tended to increase significantly since the start of the pandemic.

In the United States, participants at the September FOMC meeting estimated that headline inflation would return to 2% through 2025, although most thought core inflation was more likely to remain slightly above target in 2025.

In the UK, August projections, conditioned on market interest rates, pointed to inflation below 1 percent. Views on inflation are highly polarized. Disagreement among forecasters can provide a guide to the extent to which inflation expectations are changing.

Workers want higher wages to regain their purchasing power, risking a spiral of wages and prices, which has important implications for pricing.

The evidence from the ECB suggests that the pass-through from wages to prices is systematically higher in periods of high inflation, compared to those of low inflation.

The upward pressure on wages and prices is expected to ease as the macroeconomic backdrop weakens and slack in the labor market increases, there is great uncertainty as to the pace at which this will happen.