Aymeric Ortmans, economist at BSI Economics and doctoral student at Paris-Saclay University, answers three questions about the tools available to central banks in developed countries to combat rising inflation.
Do the inflationary pressures we are seeing today represent a major challenge for policymakers, particularly central bankers in developed countries?
Aymeric Ortmans: The return of inflation is a key concern. Since the beginning of 2021, the rise, or rather the acceleration in the rise, in price levels has been attracting the attention of central bankers. In the United States, after returning to pre-crisis levels in February 2021 (reaching nearly 1.7% year-on-year), the inflation rate stood at over 7% in December 2021, a level not seen since February 1982. In the eurozone, the consumer price index rose by 1.3% in March 2021 compared to the level observed a year earlier, before reaching 5% in December, a level not seen since the creation of the single currency.
However, despite levels well above those seen at the end of 2019, and even exceeding the respective targets of 2% set by the Federal Reserve (Fed) and the European Central Bank (ECB), inflation rates in the United States and the eurozone did not seem to cause any further concern for the two institutions, which did not react immediately to the surge in prices.
The main reason for their wait-and-see attitude in the face of inflationary pressures was primarily related to the very nature of the price increases. After welcoming a return of inflation close to their target, central bankers questioned whether the acceleration of inflation above 2% was temporary or permanent. For both the Fed and the ECB, the challenge was likely to understand the persistence of inflationary pressures without risking derailing the economic recovery by raising interest rates too early.
Central banks seem to have many tools at their disposal to combat these episodes of inflation… What are they?
Forward guidance on the future direction of monetary policy has proven to be extremely effective for central bankers over the past decade, particularly in terms of anchoring private sector expectations. Moreover, faced with the current risk of high inflation, central banks have already begun to communicate on the likely evolution of future monetary conditions.
For example, the Fed has already taken a first step toward monetary tightening by initially slowing its asset purchases (tapering). Furthermore, given the persistent nature of inflation, the Fed is now considering raising key interest rates in 2022, as interest rate management is the tool traditionally used by central banks to combat inflation. Although no timetable for increases has yet been announced, the consensus is that four increases are expected in 2022. The Bank of England, for its part, already raised rates in December 2021 (by 15 basis points to 0.25%).
For their part, the ECB and the Bank of Japan seem to have adopted a radically different strategy at this stage, with no plans to raise rates in 2022 so as not to stifle economic growth, despite high inflation.
Do you think it is possible, and above all desirable, to prevent such phenomena in the future?
It would have been possible to prevent such episodes of inflation within a very specific analytical framework, for example by being able to identify exactly the nature of the shock that caused them, or by assuming a good understanding of the transmission mechanisms at work in the economy. However, the level of uncertainty generated by the health crisis has rendered traditional analysis unsuitable for anticipating today’s inflationary phenomenon, making inflation virtually unpredictable and thus complicating the task of the monetary authorities.
For this reason, I believe it is essential for central banks to communicate their interpretation of inflation, their time horizon, and their reaction function, in other words, their systematic response to macroeconomic conditions. Anchoring expectations through communication will be difficult without a policy of rules, and therefore without explicitly stating an inflation target over a specific time horizon. The recent strategic reviews by the Fed and the ECB are also moving in this direction.
