When prices started surging in several countries around the world about two years ago, the word most often associated with inflation was “temporary”. Today, that word is “persistence.”
This was said repeatedly at the European Central Bank's 10th annual conference last week in Sintra, Portugal.
“It's surprising that inflation is continuing,” said Jerome H. Powell, chairman of the Federal Reserve.
“We have to be as resilient as inflation,” said Christine Lagarde, President of the European Central Bank.
The latest inflation data in the UK “shows clear signs it will hold,” said Andrew Bailey, Governor of the Bank of England.
Policy makers from around the world are gathering with academics and analysts to discuss monetary policy as they try to keep inflation under control. Collectively, they are sending one message: Interest rates are going to be high for a while.
Despite slowing inflation, domestic price pressures remain strong in the United States and Europe. On Friday, data showed inflation in the euro zone slowed to 5.5 percent, but core inflation, a measure of rising domestic prices, rose. The challenge for policy makers is how to meet their 2 percent inflation target, without going overboard and pushing their economies into recession.
It is difficult to judge when a turning point has been reached and policy makers have done enough, said Clare Lombardelli, chief economist at the Organization for Economic Co-operation and Development and former chief economic adviser at the UK's Treasury. “We don't know yet. We are still seeing core inflation rising.”
The tone for the conference was set late Monday by Gita Gopinath, the International Monetary Fund's first deputy managing director. In his speech, he said there was an “uncomfortable truth” that policy makers needed to hear. “Inflation is taking too long to return to targets.”
So, he said, interest rates need to stay at a level that constrains the economy until core inflation is on a downward path. However Gopinath has another troubling message to share: The world may be in for more surprises, more often.
“There is a big risk that the more volatile supply shocks of the pandemic will continue,” he said. Countries that cut global supply chains to shift production houses or to existing trading partners will increase production costs. And they will be more vulnerable to future shocks because their concentrated production will make them less flexible.
The conversation at Sintra keeps coming back to everything economists don't know, and the list is long: Inflation expectations are hard to decipher; opaque energy market; the speed at which monetary policy affects the economy appears to be slowing; and there is little guidance on how people and companies will react to successive large economic shocks.
There are also many gross errors regarding the inaccuracy of past inflation forecasts.
“Our understanding of inflation expectations is imprecise,” Powell said. “The longer inflation remains high, the greater the risk that inflation will take root in the economy. So the passage of time is not our friend here.”
Meanwhile, there are signs that the impact of high interest rates will be felt in the economy longer than before. In the UK, most mortgages are fixed rates for short terms and reset every two or five years. A decade ago, it was more common to have a mortgage that fluctuated with interest rates, so homeowners felt the impact of higher interest rates instantly. Because of these changes, “history would not be a great guide,” said Mr. Baileys.
Another bad guide is the price in the energy market. Wholesale prices for energy have been the driving force behind general inflation rates, but rapid price changes have helped inflation estimates to be inaccurate. The panel's session on energy markets reinforced economists' concerns about how ill-informed they were about something that could heavily impact inflation, due to a lack of transparency in the industry. Chart on big profit from commodity trading house last year left a lot of people in the room wide-eyed.
Economists have written new economic models, trying to quickly respond to the fact that central banks consistently underestimate inflation. But to some extent the damage has been done, and some policymakers are increasingly distrustful of the forecast.
The fact that central banks in the eurozone have agreed to be “data dependent” — making policy decisions based on available data at every meeting, and not taking predetermined actions — suggests that “we don't trust the current model enough to base our decisions on.” , at least for the most part, on the model,” said Pierre Wunsch, member of the ECB's Governing Council and head of Belgium's central bank. “And that's because we have been in shock for a year and a half.”
Given everything central bankers didn't know, the dominant mood at the conference was the need for a tough stance on inflation, with higher interest rates for a longer time. But not everyone agrees.
Some argue that past increases in interest rates will be enough to bring down inflation, and that further increases will inflict unnecessary harm on businesses and households. But central banks may feel compelled to act more aggressively to ward off attacks on their reputation and credibility, argued a vocal minority.
“Chances are they have done too much,” says Erik Nielsen, an economist at UniCredit, of the European Central Bank. This may be due to reduced confidence in forecasts, he said, which places the focus on past inflation data.
“It's like driving a car and someone paints your front sail so you can't see ahead,” he says. “You can only look through the back window to see how much inflation was last month. It may end up with you in a ditch.