William De Vijlder

The objective of central banks in most if not all advanced economies is price stability, that means keeping inflation at target. The pursuit of this objective is firmly rooted in economic theory both with respect to the implementation of monetary policy (one can think of the role of credibility or the role of time consistency) but also with respect of the analysis of the underpinings of inflation. Theory has evolved very significantly over the past decades and it continues to evolve. The objectives of this ongoing research effort being to have a better understanding of how an economy really operates and in particular  how it reacts to changes in monetary policy. We have seen this effort in the context of the massive research that has been conducted by the ECB and the Federal Reserve as part of their strategy review.

Despite the theoretical complexity, a consensus has grown amongst academics and central bankers with respect to what is driving inflation and how central banks should react. The first element is the key role played by the Phillips Curve, that is that inflation and wage growth tend to pick up when the unemployment rate goes down and vice versa. The second element is the necessity to make a distinction between demand shocks whereby demand and inflation move up and down together and supply shocks: when supply declines, inflation increases but demand suffers. The third element of the consensus view is that central banks should look through supply shocks (ignore them), that means that when you have an increase in inflation because of a decline in supply, you should actually ignore it, because eventually demand will go down and inflation should decline as well.

Despite the sophistication of the theoretical framework and the vast empirical research on what has been driving inflation in the past, we have nevertheless been surprised by inflation developments in the past twelve months. Two factors have played a key role. One is the series of supply shocks,  unpredictable events that have had an impact on the economy and on inflation : Covid-19, supply disruption, supply shortages, the war in Ukraine, huge impacts on several commodity prices and more recently, very detrimental weather conditions. All these elements were very important in creating an uplift in inflation from the supply side of the economy but demand has also been dynamic, far more dynamic that was anticipated and in that respect, income support provided by governments to households and companies during Covid-19 has played a very important role.

At the current juncture, the real issue that we are facing is twofold. One is that inflation has become very broad-based. When inflation is broad-based, it means that it pops up everywhere and makes it easier for companies to charge higher prices because their clients will understand why companies want to charge higher  prices. Another consequences is that it makes it easier to negotiate for higher wages.

Alongside the broad-based nature of inflation, there is also the fact that it has become very persistent. One year ago, central bankers were talking about the uplift in inflation, saying it was going to be transitory, now it has become persistent and this is also a real issue. A broad-based, persistent inflation implies that it has become very difficult to forecast where inflation could end up being at the end of next year.

Faced with this challenge, central banks have moved to a mode of “only data matter”. It is as if theory has been moved aside. This was very clear from the proceedings of the Jackson Hole Symposium that was held recently and which is gathering central bankers and academics. During that symposium, the message from the central bankers was really clear: it has become irrelevant to try to understand whether inflation is coming from the supply side or the demand side. What matters is that one it is elevated, way too high, secondly it is also very broad-based and thirdly it is persistent. So you need to act, you need to tighten monetary policy because the real risk that central banks are facing is that inflation expectations will become unanchored. What that means is that households would base their wage negotiation stance on an inflation assumption higher than the target of the central bank and companies will base their pricing strategy equally on an inflation expectation higher than that set by the Fed or the ECB.

So, message from both the Fed and the ECB has been our commitment to achieve our inflation objective is unconditional, whatever the cost to the real economy, we will hike interest rates because we want to slow down growth sufficiently to engineer a slowdown of inflation.

We have to hope that developments on the supply side, that is the absence of new negative shocks will help them pursue this objective.