Inflation Returns //
The financial crisis of 14 years ago and the sudden surge in inflation since last year have frightened financial experts. Both originated in the United States and then spread globally.
(Image from Helo)
That's what Agustín Carstens, the bank's general manager for international settlements, said in a speech on Tuesday that a return in inflation, like the 2008 financial crisis, could eventually fundamentally change the mindset and priorities of policymakers.
Agustín Carstens, who was also former governor of Mexico's central bank, also said: "We need to be open to the possibility that the inflationary environment is undergoing fundamental changes." The perspective we use to interpret economic development since the 1990s may no longer be sufficient. ”
There is a deep-seated view that the financial crisis is mainly a self-regulation of the market, with individual stocks and sectors falling sharply but not having a broader impact on the financial system. Similarly, Agustín Carstens argues, inflation was self-correcting in the decades leading up to the pandemic, with price fluctuations in one sector rarely spilling over into broader inflation trends. Central banks have learned to "see through" supply shocks rather than raise interest rates to cope.
Agustín Carstens noted that the "low inflation environment of previous decades has given central banks a lot of room to focus more on other goals such as economic growth and full employment." Central banks also recognize that low interest rates can trigger financial instability, a sign that the Swiss-based central bank consortium, the Bank for International Settlements (BIS), has often warned of. But inflation is usually not part of the trade-off for central banks."
How is it different now from the 90s? //
First, the return of inflation was almost universally unexpected, including by the Bank for International Settlements. Inflation in the United States in 2021 was five percentage points higher than expected at the beginning of the year, while the euro area rose by four percentage points. Agustín Carstens noted that forecasts are often wrong, but last year's mistakes were "beyond what many thought were reasonable."
Second, the return to inflation, while most pronounced in the United States, is global. Currently, 58% of advanced economies have inflation rates of more than 5%, and 55% of emerging economies have inflation rates of more than 7%. This is not all due to energy: inflation, excluding energy, has also generally accelerated. This suggests that U.S.-specific factors, such as last year's stimulus package, may only explain rising inflation by one to two percentage points. As for the rest, global considerations need to be taken into account.
Agustín Carstens also noted that after the COVID-19 lockdown was lifted, demand rebounded more rapidly than expected, in part because of extensive economic stimulus in countries such as Europe and the United States, which also meant that the economic recovery was in fact much weaker.
The pandemic has also shifted demand from services to commodities. As demand for commodities exceeds capacity, prices soar, but this is not offset by deflation in the services sector, where demand is weak and prices tend to be "sticky" Most economic models ignore this because they base inflation on aggregate demand levels rather than what it constitutes.
Most surprisingly, supply has been slow to respond to the recovery in demand, as opposed to what happened after the financial crisis. "Staggered blockades disrupt global value chains and logistics networks, revealing the 'fragility' of 'just-in-time' manufacturing systems," Kastens explains. ”
Supplies of oil and other commodities have been affected by low investment, as well as the reluctance of some producers to boost production, which have been scarred by previous price declines. Supply bottlenecks in some industries, such as semiconductors, are widespread because they occur in projects at the beginning of the production chain that are necessary for the downstream production of other goods and services."
It's reminiscent of the financial crisis, when the Fed initially thought subprime mortgage defaults would be contained because it didn't realize how an interconnected, highly leveraged financial system could amplify its impact.
Agustín Carstens believes that the greater risk of supply-driven price increases depends on the overall environment. Statistically speaking, in a high inflation environment, there is a high correlation between prices, that is, the increase in one price will spread to other prices. In contrast, low-inflation conditions tend to be largely self-correcting: large price increases in individual commodities can exacerbate inflation over a period of time. But if other prices don't react, inflation will eventually fall. When negotiating wages, people don't take into account low inflation. Thus, a sudden shock from a sectoral price increase does not trigger a wage-price spiral.
Whether we are now moving from a low-inflation environment to a high-inflation environment is the biggest question facing central banks. The Fed disagrees, citing long-term inflation expectations remaining stable. Still, the Bank for International Settlements sees some troubling signs: Price increases in one sector are increasingly spreading to others. The impact of prices on wages has been steadily declining for decades and is now rising.
Agustín Carstens suggests that if the public's mentality about inflation changes, then central banks must also change.
If there is a silver lining, central banks saw such inflation in the 1970s and knew how to avoid a recurrence, just as knowledge of the Great Depression helped them avoid a repeat in 2008. Even so, the 2008 experience didn't make it any more enjoyable.
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