The COVID-19 pandemic continues to challenge central banks. When the pandemic struck and economies nosedived, the pressure was on central banks to rescue and sustain the economy. This led to a fast opening of liquidity floodgates to stay the economy humming. A year later fortunes have changed. And now an increase in inflation has put pressure on central banks to tighten the hosepipes they opened last year. How do central banks deal with this sudden change of events?
The accompanying graph pictures this turnaround of fortunes during a few selected advanced economies. We see that since the pandemic in February 2020, inflation in these economies which was already less than the target of two percent, started drifting even lower. The low inflation indicated low demand which was due to global a slowdown as policymakers imposed lockdowns that curtailed economic activity.
From Jan 2021 onwards, we see rise in inflation due to stronger recoveries in economies and partly due to the bottom effect. In its June 2020 outlook, the International fund had projected the planet economy and advanced economies to shrink 4.9 percent and eight percent respectively in 2020. Since then, IMF has upgraded its forecast in subsequent outlooks. within the recent July 2021 outlook, it said the planet economy and advanced economies contracted 3.2 percent and 4.6 percent in 2020.
Central banks have come struggling thanks to this sudden rise in inflation. However, thus far they need stayed faraway from tightening monetary policy. The catchword for central banks regarding inflation is ‘transitory’ as seen in recent monetary policy statements of Federal Reserve System , European financial institution and Bank of England. IMF’s July outlook also used an equivalent word.
Why aren’t central banks worried? There are multifold reasons.
First, central banks actually are going to be proud of inflation being above target. For nearly a decade now, the inflation in developed countries has been less than targeted resulting in criticism. This was obviously ironical as central banks are often criticized for higher inflation. The Federal Reserve System even tweaked its framework from inflation targeting to average inflation targeting (AIT). Under AIT, if inflation has been lower for a particular period, the Federal Reserve System will allow inflation to be higher in order that average inflation over the whole period to be 2 percent.
Second, there's still slack within the economy and growth and unemployment are still not at pre-pandemic levels. this needs continued support from central banks.
Third, inflation has risen thanks to supply chain disruptions which are gradually easing with rising vaccinations and normalcy.
Fourth, commodity prices have also played a task within the recent rise in inflation. Core inflation, which excludes fuel and food prices, is high only within the case of the US.
Fifth, high inflation is additionally on account of the bottom effect. The chart shows that inflation ebbed in Feb 20 then begins to rise in Feb 21 (For the Euroarea, in December). So, albeit the inflation index has increased marginally from Feb 2021, the change from last year are going to be magnified as index had dipped last year. this is often the bottom effect. As a result, IMF within the July 21 outlook notes “the current spikes in annual inflation partially are the results of mechanical base effects from last year’s low commodity price”.
Last but not least, is that the important factor of inflation expectations. If inflation expectations also go up, then central banks poise themselves for action. In the US, while survey-based inflation expectations have edged up, those tracked by financial markets have remained on the brink of the inflation target. In Europe and UK, inflation expectations are broadly anchored.
Having said that, if current inflation remains elevated, inflation expectations also will inch up creating concerns for central banks.
Coming to Emerging and Developing countries (EDCs), inflation has risen there too. Unlike developed countries, EDCs are never during a comfortable position on the inflation front as food prices have both higher weightage within the inflation basket and influence inflation expectations.
On the highest of it, EDCs also will be watching inflation trends in developed countries. If inflation continues to travel up in developed world, pushing central banks to tighten monetary policy before expectations, one could see capital outflows from the EDCs. this is often what we saw in 2013 when Fed chair Ben Bernanke just announced the likelihood of tapering policy resulting in tantrums and chaos in EDC markets.
To sum up, inflation seems to be back after being within the wilderness for quite a decade. Ever since the 2008 crisis, economists are divided inflation in two camps. The pessimists have constantly warned that inflation is round the corner. On the opposite hand, the optimists have suggested that central banks needn't worry about inflation and will instead specialize in growth.
When inflation had remained muted, the policy weight was towards the second camp. The virus shock has brought inflation back to the discussion. Developed country central banks might not be worried over inflation now, except for how long is yet to be seen.
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