Inflation
Policy response aside, whether inflation becomes entrenched or not ultimately
depends on whether wage-price spirals will develop. The risk should not be
underestimated, owing to the inherent dynamics of transitions from low- to highinflation regimes.
Three reasons stand out. First, we have already seen outsize and persistent
increases in especially salient prices, such as those of food and energy. Households
and workers’ perceptions of inflation and expectations of its future evolution are
especially sensitive to them. Second, given the broadening of price pressures,
inflation in general has no doubt moved out of the zone of “rational inattention”,
within which it has little impact on behaviour, into that of sharp focus, in which it
starts to influence behaviour more substantially. Finally, price-induced cuts in real
wages are likely to prompt workers to seek to recoup the loss of purchasing power.
Similarly, firms should find it easier to translate higher wages into higher prices
given how generalised wage and cost pressures are.
We may be reaching a tipping point, beyond which an inflationary psychology
spreads and becomes entrenched. This would mean a major paradigm shift.
These observations underscore some stylised features of the inflation process,
as analysed in detail in Chapter II. For a start, low- and high-inflation regimes are
very different animals. When inflation settles at a low level, it reflects mainly changes
in sector-specific, or relative, prices as opposed to more synchronised ones. In
addition, it exhibits self-equilibrating properties, as these price changes, including
those of “salient” items such as oil and food, tend to leave only a temporary imprint
on inflation. One reason is that, as the idiosyncratic fraction of price changes is
greater, differences in the price indices that matter for individual agents – households
and firms – are commensurately larger. Not only is economy-wide inflation less
noticeable, it is also less relevant. High-inflation regimes are the mirror image of
low-inflation ones. In particular,
they don’t exhibit self-equilibrating properties, price
changes are much more synchronised and inflation is much more of a focal point for
the behaviour of economic agents, exerting a major influence on it.
This also means that transitions from low- to high-inflation regimes tend to be
self-reinforcing. As inflation rises and becomes a focal point for agents’ behaviour,
behavioural patterns tend to strengthen the transition. Agents redouble their
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efforts to protect themselves from losses in purchasing power or profit squeezes,
both actual and, increasingly, prospective ones. And wage negotiations tend to
become more centralised, while demands for indexation proliferate and contract
lengths shrink.
Put differently, when changes in relative prices are large and persistent enough,
they test the self-equilibrating properties of the low-inflation regime. All the more
so if labour and product markets are tight, which puts further upward pressure on
both prices and wages.
From this perspective, so far, the signs are not entirely reassuring. True, wage
growth has been uneven across countries. It has been especially strong where
aggregate demand pressures have been more in evidence, not least in countries
that have made large terms-of-trade gains or have a history of high inflation. Hence
the differences between Latin America and Asia. But in many countries, a substantial
part, if not the bulk, of wage renegotiations are still to come. And in some of them
demands for higher indexation and more centralisation of wage bargaining have
already surfaced. Moreover, terms-of-trade losses may actually strengthen costpush inflationary pressures with a lag: when the cake becomes smaller, the fight
over it becomes bigger.
Growth
Two specific factors darken growth prospects at the current juncture: much of the
impact of developments in commodity markets is still to be felt, and macro-financial
vulnerabilities loom large. These factors matter in and of themselves. But they are
especially significant against the monetary policy tightening under way.
So far, the effect of commodity market ructions has operated mainly through
higher prices. It would become much bigger should supply constraints kick in as
well.
As regards energy, embargoes and price caps are on the horizon or being
implemented. Furthermore, investment in fossil energy sources has been remarkably
subdued, not least owing to the uncertainty-fraught transition towards zero
emissions.
As regards food, a crisis looms ahead. The war has wreaked havoc with the
supply of staples, such as wheat, and of fertilisers, which will greatly curtail crop
production. In addition, the tendency to cut food exports to favour the domestic
market inhibits distribution across the world and discourages production. Finally,
soaring food prices threaten to trigger major social and political unrest, especially
in lower-income countries. A food crisis is a humanitarian calamity that may also
have crippling consequences for the economy.
What about the conjunction of historically high private debt levels and elevated
asset prices? Much will depend on the evolution of interest rates and their knockon effects on financial markets, since high indebtedness heightens the sensitivity of
expenditures and the risk of financial strains.
A simple, highly stylised statistical exercise developed in Chapter I sheds some
light on this question, suggesting that the sensitivity of the economy to interest
rates is substantial. At one extreme – used purely as an analytical reference – in a
scenario in which interest rates are held constant, asset prices continue to rise
alongside debt levels, pointing to a further build-up in vulnerabilities.
In one in
which interest rates follow the market-implied path, by 2025 GDP could be roughly
1.5% lower relative to the constant-rate baseline. And if they follow the steeper
path of the early 2000s, by 2025 debt service ratios could climb back to their GFC
levels while both house and equity prices would see steep declines. As a result, the
shortfall of GDP relative to the baseline is around 3%.
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Naturally, these results are purely illustrative. They are based on average
relationships since the mid-1980s for a number of AEs and are subject to substantial
uncertainty. That said, they provide a sense of the orders of magnitude involved
and hence of the trade-offs faced by policymakers.
Moreover, macro-financial vulnerabilities need not weigh down on growth only
if interest rates increase. This is the case in China, where the authorities have sought
to contain the build-up of risks in the real estate sector – a key driver of growth for
the country – so as to make growth more sustainable. Indeed, the combination of
financial imbalances and stringent lockdowns casts a long shadow on China’s
growth prospects and hence on those of the global economy.
