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At the Front Lines of the Inflation Fight, Uncertainty Reigns

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About two years ago, when prices started rising in several countries around the world, the word most commonly associated with inflation was “temporary.” Today’s word is “persistence”.

This was repeated at the 10th European Central Bank Annual Meeting in Sintra, Portugal last week.

“It’s amazing that inflation has persisted so long,” said Federal Reserve Chairman Jerome H. Powell.

European Central Bank President Christine Lagarde said: “We have to be as persistent as inflation is to persist.”

Bank of England Governor Andrew Bailey said Britain’s latest inflation data “show clear signs of sustainability”.

Policymakers from around the world met with academics and analysts to discuss monetary policy designed to keep inflation down. Collectively, they sent a single message: “Interest rates are going to be higher for a while.”

Inflation is slowing, but domestic price pressures remain strong in the United States and Europe. Data on Friday showed eurozone inflation slowing to 5.5%, but core inflation, a measure of rising domestic prices, rose. The challenge for policymakers is how to hit the 2% inflation target without forcing the economy into recession.

Claire Lombardelli, chief economist at the Organization for Economic Co-operation and Development and former chief economic adviser to the UK Treasury, said it was difficult to tell when a tipping point had been reached and whether enough action had been taken by policymakers. “We don’t know yet. Core inflation is still rising.”

On Monday night, International Monetary Fund First Deputy Managing Director Gita Gopinath set the mood for the conference. In her speech, she said there are “unpleasant truths” policymakers need to hear. “It’s taking too long for inflation to return to target,” she said.

That is why interest rates should keep the economy constrained until core inflation is on a downward trajectory, he said. But Gopinath shared another disturbing message. The world will probably face more shocks more often.

“There is a big risk that the more volatile supply shocks of the pandemic era will continue,” he said. Costs of production will rise as countries cut global supply chains to shift production to their own countries or to existing trading partners. And it will be more vulnerable to future shocks as production concentration reduces flexibility.

The conversation in Sintra was full of things economists didn’t know, and the list was long. Inflation expectations are hard to decipher. Energy markets are uncertain. The rate at which monetary policy affects the economy appears to be slowing. And there is little guidance on how people and businesses will react to a series of major economic shocks.

There have also been a number of serious errors in past inflation forecast inaccuracies.

“Our understanding of inflation expectations is not accurate,” Powell said. “The longer inflation remains high, the greater the risk that inflation will become entrenched in the economy. So the passage of time is not on our side here.”

On the other hand, there are also signs that the impact of high interest rates will take longer to be reflected in the economy. In the UK most mortgage rates are fixed for short periods and reset every 2 or 5 years. Ten years ago, variable mortgages were common, so homeowners felt the impact of rising interest rates immediately. Because of this change, “history is not a good guide,” Bailey said.

Another inadequate indicator is energy market prices. Wholesale energy prices are the driving force behind headline inflation, but sharp price volatility contributes to imprecise inflation forecasts. During a panel session on energy markets, economists’ concerns were heightened that the industry’s lack of transparency meant that they were not getting enough information about what would have a big impact on inflation.chart above Huge profits for commodity trading companies Last year, many people at the venue rolled their eyes.

Economists have created new economic models in an attempt to quickly respond to the fact that central banks have consistently underestimated inflation. But some damage has already been done, and some policy makers are increasingly skeptical of the forecast.

The fact that the eurozone central bankers have agreed to be “data dependent” – to take no pre-determined actions and base their policy decisions on the data available at each meeting – is , indicating that “we currently do not have enough trust in the models on which decisions are based.” At least a large part of it is model-based,” said Pierre Unsch, ECB board member and Belgian central bank governor. “It’s because we’ve been amazed for a year and a half.”

Given all the things central bankers don’t know, the prevailing mood at the meeting was the need for a tougher stance on inflation with longer interest rates. However, not everyone agreed.

Some argued that past rate hikes were enough to keep inflation in check and that further rate hikes would cause unnecessary pain to businesses and households. But central bankers may feel compelled to act more aggressively to avoid attacks on their reputations and credibility, argued a vocal minority.

“They’ve probably gone too far already.,” UniCredit economist Eric Nielsen said of the European Central Bank: Perhaps this is happening because there is less confidence in forecasts and more emphasis on historical inflation data, he said.

“It’s like driving a car and someone paints the front screen so you can’t see,” he says. “The only way to see last month’s inflation rate is to look through the rear window. It will probably end up leaving you in a ditch.”

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