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Tomasz Wieladek serves as the chief European economist at T Rowe Price and is a CEPR Research Fellow
The approach of inflation to target levels in advanced economies is finally happening. Does this signal a return to the era of low and stable inflation observed in the decades prior to the pandemic?
Investors appear to believe so. In the Euro Area and the US, five-year / five-year inflation swaps are nearing their respective targets.
Many professional forecasters share this sentiment. Analysts’ consensus long-term inflation forecast for the euro area is 2 per cent, and the range of opinions has decreased to normal levels. Similarly, forecasters have been recalibrating their long-term US inflation expectations. The general belief is that inflation will revert to its previously uneventful state.
However, I hold a different view. Changes in central bank policies, expectations, labor markets, and globalization suggest that inflation will likely remain volatile in the future.
Central banks responded decisively to the recent inflation surge. Yet, accurately adjusting policy responses in real-time, amidst numerous variables, is nearly impossible.
Active fiscal policies to bolster the business cycle compound this challenge. Both monetary and fiscal policies typically exhibit prolonged and uncertain delays. Consequently, central banks are prone to either undershooting or overshooting their targets.
The extent to which policy was excessively tightened or remains overly loose will determine the magnitude of this deviation from the target. Nevertheless, if inflation consistently strays from the target in the future, central banks are likely to intervene once more. Depending on the circumstances, this could pave the way for another substantial inflation target miss.
The truth is that fine-tuning monetary policy to contain inflation in the face of structural changes is exceedingly difficult. The best course for central banks is to achieve progressively smaller fluctuations in inflation until the optimal policy setting becomes evident.
Stable and well-anchored inflation expectations are the cornerstone of low and stable inflation. However, inflation expectations remained stable precisely because inflation was low and stable. Central banks were deemed as the custodians of price stability, ensuring that inflation would stay on target irrespective of circumstances. Recent events (and substantial forecast inaccuracies) have significantly challenged this perception.
Consequently, inflation expectations are likely to detach much quicker in response to new inflation shocks compared to previous instances. This will amplify future inflation shocks and foster greater persistence.
Labor markets in advanced economies have remained highly constricted, even during economic slowdowns. The pandemic’s impact on labor force participation and restrictions on immigration have curtailed the abundant labor supply that advanced economies enjoyed in recent decades. As more workers retire, population aging will exacerbate these labor scarcities.
Consequently, employees have witnessed a notable increase in bargaining power, reminiscent of several decades ago. For instance, German industrial unions continue to demand substantial wage settlements, despite the weakened state of German industry. The rise in bargaining power will likely heighten inflation persistence and elevate second-round effects.
Globalization played a pivotal role in maintaining low and stable inflation over the past few decades. Trade openness facilitated the relocation of production to the most cost-effective locations, enhancing the flexibility of the economy’s supply side. This helped counterbalance the inflationary impact of local demand shocks. However, geopolitical risks have rendered global supply chains considerably less resilient. Ongoing and anticipated tariff escalations between the EU, US, and China could further exacerbate this trend. Consequently, global supply chains are unlikely to mitigate inflationary pressures as effectively as in the past.
Various inflation risks loom on the horizon. Countries will need to ramp up investments to address climate change. Increased military expenditures, particularly in European nations, will also absorb a significant share of resources. Government spending will expand the economy’s supply side and contribute to long-term disinflation. However, the short-term strain on limited resources may produce the opposite effect.
The extensive proliferation of AI technology in the US will necessitate a substantial amount of energy. The US economy could revert to being a net energy importer. This could have adverse inflation ramifications for European countries that rely on US LNG imports. While AI is expected to have a disinflationary impact in the medium term, the associated energy consumption could fuel short-term inflation.
All these factors compound the challenge of formulating a well-calibrated monetary policy response. In this milieu, significant fluctuations in inflation are markedly more probable than in the past. Consequently, inflation volatility is here to stay. Policymakers and investors must acknowledge the risk that inflation will not become mundane anytime soon.