Uncertainty reigns on the front line of the inflation battle

When prices started rising in multiple countries around the world about two years ago, the word most often associated with inflation was “transient.” Today the word is “perseverance.”

That was said repeatedly at the 10th annual conference of the European Central Bank this week in Sintra, Portugal.

“It’s surprising that inflation is so stubborn,” said Federal Reserve Chairman Jerome H. Powell.

“We have to be as persistent as inflation is persistent,” said Christine Lagarde, the president of the European Central Bank.

Andrew Bailey, the governor of the Bank of England, said Britain’s latest inflation data showed “clear signs of persistence”.

Policymakers from around the world gathered with academics and analysts to discuss monetary policy as they try to curb inflation. Collectively, they sent one message: interest rates will be high for a while.

Even as inflation slows, domestic price pressures remain strong in the United States and Europe. On Friday, data showed inflation in the eurozone slowed to 5.5 percent, but core inflation, a measure of domestic price increases, rose. The challenge for policymakers is how to meet their 2 percent inflation target without overdoing it and pushing their economies into recession.

It’s hard to judge when a turning point has been reached and policymakers have done enough, says Clare Lombardelli, chief economist at the Organization for Economic Co-operation and Development and former chief economic adviser at the UK Treasury. “We do not know yet. We are still seeing core inflation rising.”

The tone of the conference was set Monday evening by Gita Gopinath, the first deputy director of the International Monetary Fund. In her speech, she said there was an “inconvenient truth” that policymakers needed to hear. “Inflation is taking too long to get back on target.”

And so, she said, interest rates should be at levels that constrain the economy until core inflation is on a downward path. But Ms. Gopinath had another disturbing message to share: the world is likely to experience more shocks more often.

“There is significant risk that the more volatile supply shocks of the pandemic era will persist,” she said. Countries cutting off global supply chains to move production home or to existing trading partners would increase production costs. And they would be more vulnerable to future shocks because their concentrated production would give them less flexibility.

The talks in Sintra kept coming back to everything economists don’t know, and the list was long: inflation expectations are hard to decipher; energy markets are opaque; the speed at which monetary policy affects the economy appears to be slowing; and there is little advice on how people and businesses will respond to major successive economic shocks.

There were also plenty of mea culpas about the inaccuracy of previous inflation forecasts.

“Our understanding of inflation expectations is not accurate,” said Mr. Powell. “The longer inflation remains high, the greater the risk of inflation settling into the economy. So the passage of time is not our friend here.

Meanwhile, there are signs that it will take longer for the impact of high interest rates to be felt in the economy than it used to. In Great Britain, the vast majority of mortgages rates that are fixed for a short period and are therefore revised every two or five years. A decade ago, it was more common to have mortgages that fluctuated with interest rates, so homeowners immediately felt the impact of higher interest rates. Because of this change, “history will not be a good guide,” said Mr. Bailey.

Another bad guide is the prices in the energy markets. The price of wholesale energy has been the driver of overall inflation rates, but rapid price changes have contributed to making inflation forecasts inaccurate. A panel session on energy markets amplified economists’ concerns about how underinformed they are about something that strongly affects inflation, due to a lack of transparency in the industry. A chart on the mega profits of commodity trading houses last year many in the room left wide-eyed.

Economists have written new economic models, trying to respond quickly to the fact that central banks have consistently underestimated inflation. But to some extent the damage has already been done and some policymakers are growing mistrust of the forecasts.

The fact that eurozone central bankers have agreed to be “data-dependent” – making policy decisions based on the available data at each meeting, and not taking predetermined actions – shows that “we don’t trust models enough now to base decision”. , at least largely, on the models,” said Pierre Wunsch, a member of the Governing Council of the ECB and the head of the Belgian central bank. “And that’s because we let ourselves be surprised for a year and a half.”

Given everything the central bankers don’t know, the prevailing mood at the conference was the need for a tough stance on inflation, with interest rates higher for longer. But not everyone agreed.

Some argued that interest rate hikes in the past would be enough to reduce inflation, and that further hikes would unnecessarily hurt businesses and households. But central bankers may feel compelled to act more aggressively to fend off attacks on their reputation and credibility, a vociferous minority argued.

“Chances are that they have already done too much“ Erik Nielsen, an economist at UniCredit, said of the European Central Bank. This is likely due to declining confidence in forecasts, he said, putting an emphasis on past inflation data.

“That’s like driving a car and someone has painted your windshield so you can’t see ahead,” he said. “You can only look through the back window to see what inflation was last month. That probably ends with you in the ditch.”