Inflation characteristics

“Nothing is as permanent as a temporary government program.”

Milton Friedman

Recent price increases are unlikely to usher in a period of structurally higher inflation. The rebound in core inflation is less threatening if base effects and some movements related to the pandemic are taken into account.

Given the implications of high and sustained inflation, it is necessary to look for the origin of the changes in the inflationary process, before tightening the Monetary Policy in response to its negative effects on economic activity and job creation.

Fluctuations in headline inflation in advanced economies over the past 30 years are largely explained by specific shocks in some sectors, rather than by generalized trends in the prices of products and services.

This partly reflects the price shocks that only trigger second-round inflationary effects, which is how the situation is called in which the rise in inflation causes wage increases, which in turn generate inflationary pressures to the extent that are not accompanied by increases in productivity.

The inflation targeting regime has meant that companies and workers expect abrupt inflationary movements to be transitory, allowing companies and workers to choose not to modify their price or wage demands in immediate response.

Structural factors have made wages less sensitive to price shocks, inhibiting one of the channels through which second-round inflationary effects are built.

Globalization and developments in supply chains have increased competition and reduced pricing power, limiting the extent to which companies can pass their cost increases onto their selling prices.

If the current inflation rate is compared to that of the previous five years, these surges do not suggest that we are returning to the inflationary world of the early 1980s. Although recent inflation spikes have been large, the rebound is not fundamentally different. to that observed during previous transitory inflation peaks.

The academic literature suggests that there may be some reasons to ignore extreme inflationary movements in the event of supply shocks.

If a supply shock shifts the optimal price charged by some firms significantly upward and slightly reduces the optimal price for most other products, then in a fully flexible world, the aggregate variation in prices may be small. Although price adjustments incur costs, so companies whose optimal price has fallen slightly can wait until their next review to adjust them. Therefore, in the short term, inflation will increase, although aggregate prices are likely to converge to the same point as in a completely flexible world.

Conversely, if there is a demand shock, leaning toward certain products, such as consumer durables, inflation measures may underestimate underlying inflationary pressures.

It is tempting to argue that supply factors are playing a larger than normal role in price behavior at the moment and that eliminating extreme price movements is sensible to gauge underlying inflationary pressures. This ignores the fact that the relative importance of supply and demand factors can differ from one economy to another.

Leave a Comment