Analysis: How should central banks respond to transitory inflation?
Central banks globally are seeing inflation higher than expected, and seeing elevated inflation persisting for longer than expected. But that does not necessarily mean tighter monetary policy is the appropriate response in all cases, and responses will differ between central banks with the RBA still likely to lag the Fed in hiking rates.
As transitory inflation has persisted for longer than expected, the pressures driving inflation higher have also morphed. The initial spike in inflation rates was driven by base effects from pandemic price reductions and subsequent rebounds. This was the initial conception of transitory inflations and is still keeping headline rates elevated.
But supply chain disruptions have intensified and become more prolonged, while commodity prices, notably energy prices, have surged, with initial reopening impacts giving way to a new supply-driven inflationary impulse. Fiscal and monetary policy settings continue to support demand, but ongoing supply disruptions expectations for continued normalisation in composition of demand has impeded supply response.
Supply driven inflation spike are difficult for monetary policy to respond to. Tightening monetary policy to reduce demand in aggregate in response to relative price shifts from demand and supply mismatches and a constrained supply response is undesirable. But some policymakers are growing more attuned to the risk that higher inflation becomes more embedded.
The IMF, although expecting inflation to fall back by mid next year has warned of that “prolonged supply disruptions, commodity and housing price shocks, longer-term expenditure commitments, and a de-anchoring of inflation expectations could lead to significantly higher inflation than predicted in the baseline”. Thus, inflation expectations will be key to watch over the next few months and into 2022.
Higher for longer inflation has led to a change in tone from some central banks. The new BoE Chief Economist said that “risks to the economic and inflation outlook are again clearly becoming two-sided.” Though the Fed’s Brainard indicated that the temporary factors adding to tightness to the labour market should recede as COVID disruptions ease, saying “once COVID constraints recede, I see no reason the labor market should not be as strong or stronger than it was pre-pandemic.”
As for Australia, we are unlikely to get a true read of the underlying pace of inflation until mid-2022, with both transitory and policy driven impacts continuing to play out. The dip in activity alongside lockdowns is likely to see an even longer period of spare capacity persist in the economy and the partial reversal of recent labour market gains is likely to delay the anticipated pickup in wage growth. How global inflation pressures translate into Australia will be discussed in our upcoming Q3 CPI preview and in more detail in an upcoming Weekly.