TL;dr: don't let the genie out of the bottle. Do not let the genie out of the bottle
From The Bank for International Settlements.
BIS Papers | No 133 |20 March 2023Foreword by Agustín Carstens, BIS General Manager
Focus
The global surge of inflation that started in 2021 took most observers by surprise. While unforeseen shocks played a key role, the surprise also highlighted limitations of the analytical frameworks typically used to understand and forecast inflation.
Contribution
This study provides a new view of the inflation process. It characterises the process as two regimes – a low- and a high-inflation regime – with self-reinforcing transitions from the low- to the high-inflation one. The value added of this view is to highlight those elements that standard models downplay and to draw new implications for monetary policy.
Findings
First, inflation tends to be self-stabilising in a low-inflation regime but loses that property as it shifts to the high-inflation one. This reflects systematic differences in the co-movement of individual prices and in the behaviour of wage and price setters that determines them. As inflation increases above very low levels, it becomes a more focal point for workers and firms. This increases the likelihood of wage-price spirals.
Second, monetary policy has a smaller impact on inflation in a low-inflation regime, where individual price changes co-move little. It also operates through a quite narrow set of sectoral prices, typically in the services sectors that are more sensitive to economic activity.
As a result, when inflation has settled at a low level, monetary policy can afford to accept moderate, even if persistent, deviations from narrowly defined inflation targets. But it has to respond in a timely and forceful way when transitions to a high-inflation regime threaten....
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