Understanding the inflation crisis: The importance of a clear narrative

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Over the past three years, the global economy has a faced a series of substantial price shocks. The outbreak of Covid-19 in 2020 was followed by Russia’s full-scale invasion of Ukraine in early 2022, putting economies around the world under immense strain. This column highlights the importance of understanding the narrative of these shocks for analysing subsequent macroeconomic conditions. Only when policy-makers have got to grips with the economic effects of these episodes will they be able to deliver sufficient policies to support recovery and resilience.

The recent period of high and persistent inflation has spurred a barrage of criticism against central banks. Monetary authorities are accused of being too slow to react, with views being much less sanguine when it came to fiscal policy. This raises questions about how best to share the burden of monetary policy adjustments. In this blog, we provide further context to this discussion, proposing a narrative of the crisis that may help frame the policy and academic debate.

The charts below are taken from the 2023 Barcelona report (Figure 1). The two panels plot quarterly core inflation against output for both the euro area and the United States. To avoid misinterpretation, it should be noted that the two figures are not Phillips curves. Plotting a Phillips curve would require taking a stand on potential output, expectations of inflation, and the effect of energy price spikes and other shocks on inflation at any given level of aggregate demand. The figures instead plot core inflation – the measure most relevant for policy decisions – against aggregate economic activity.

This provides a visual aid for showing the three-phase narrative of the macroeconomic response to Covid-19 and Russia’s full-scale invasion of Ukraine. The first phase corresponds to the eruption of the pandemic (first two quarters of 2020) and is marked by a sharp decline in output accompanied by mild deflation, reflecting a change in behaviour dictated by fear of contagion and the deployment of policy measures limiting people’s mobility. The second phase – the re-opening – runs from the last two quarters of 2020 through to the first two quarters of 2021. It is marked by a sharp rebound of output and early signs of inflation. The last phase coincides with the inflation crisis we are living through today, where an early spike in headline inflation has ignited a strong and persistent dynamic of core inflation, despite the monetary contraction from the second half of 2022 onwards. 

In the first phase of the crisis, the global economy was steered successfully away from systemic collapse. This was due in a large part to the strong policy response to the pandemic, especially among advanced countries. Total output contracted sharply, but only for a limited time. Yet, the outburst of the pandemic coincided with an unprecedented reallocation of demand and supply across sectors, creating imbalances in the market for goods relative to services, with a sharp hike in the relative price of goods exacerbated by supply chain bottlenecks. The labour market in the two sectors polarised correspondingly – tight in the goods sector and slumping in the services sector. Because of these divergent developments, the traditional indicators of economic slack (output gap, unemployment and participation rates, employment, vacancy ratios) stopped moving together and started to give contrasting signals. 

Throughout the first and second phases, the demand for goods remained very strong almost everywhere. Goods are tradable (hence cross-border prices tend to align) and relatively intense in energy and commodities. This meant that through the reopening period, the early swing in goods demand in each country compounded into a global driver in the price of intermediate goods and commodities. At this stage, the monetary and fiscal stance remained expansionary, accommodating the hikes in these prices and, later, the catch up of the price of services and eventually of wages. On top of this, the energy crisis following the Russian invasion of Ukraine created a divide across the Atlantic, with a sharp terms of trade deterioration in Europe and other energy-dependent regions, but not in the United States.


Figure 1: The three phases of the inflation crisis. Core inflation plotted against output (euro area vs United States)

 Source: 2023 Barcelona report    


What does this story tell us? The narrative of the inflation crisis outlined above underlies the need to dig deeper into the logic and the dynamics of shocks that induce very large relative price movements across sectors. By way of an example, the authors of the 2023 Geneva report propose a multi-sector model, featuring energy, manufacturing, and services (Guerrieri et al., 2023). In the model, prices are stickier in the services sector than in the manufacturing sector and are more flexible in the energy sector. Wages are stickier than any of these prices. This means that shocks propagate at different speeds – faster in the goods sector and with a delay in the services sector.

In principle, the monetary and fiscal authorities can decide to set average inflation (around which relative prices adjust in time) at any level they want. But because of the different speed of price adjustment across sectors, different rates of average inflation will correspond to sharply different dynamics of output and employment. Keeping inflation low throughout the process requires monetary policy to implement a contractionary stance from the outburst of the shocks (essentially suppressing the nominal adjustment of service prices and wages). But since services prices and wages are sticky, a low average inflation comes at the cost of exacerbating the downturn caused by the shocks themselves. In contrast, keeping a sufficiently high level of employment and output requires policy-makers to accommodate a sufficiently high level of inflation over the period required by the propagation mechanism to realign relative prices and real wages.

At times of high uncertainty, policy making is inherently risk management. A low-inflation path exposes the economy to the risk of deep downturn plagued by all kinds of adverse dynamics (in investment and debt costs, for example). A high-inflation path may expose the economy to the risk of de-anchored expectations. In either case, political disagreement on distribution and budget policies may complicate the dynamics of inflation propagation further.     

The importance of a clear narrative of the inflation crisis cannot be overestimated. It is vital for paving the way for the correct policy response and assessing the space for monetary and fiscal interventions. It is also an essential component for clear and convincing communication by policy-makers (particularly central banks), which is itself critical for keeping expectations aligned with policy objectives.


Author: Giancarlo Corsetti