Inflation: a Look under the Hood

After completing this reading, you should be able to:

• Describe how inflation dynamics differ between a low-inflation regime and a high-inflation regime.
• Explain the process of wage and price formation, the role inflation plays in this process, and vice versa.
• Describe the various channels through which inflation expectations manifest in financial markets and discuss the inference of inflation expectations from financial markets.
• Describe the operation of a central bank’s monetary policy in a low-inflation regime and evaluate indicators a central bank can use for timely detection of transitions to a high-inflation regime.

Individual Price Changes and Inflation

Some unknown aspects regarding inflation are revealed by carefully examining the behavior of sector-specific pricing:

1. When inflation has stabilized at a low level, its development mainly reflects individual changes in sector-specific prices rather than the co-movement of prices.
2. The well-documented drop in inflation volatility that is linked to reduced inflation is due to their co-movement rather than the individual price fluctuations themselves. The distribution across prices becomes more subdued in an environment of low inflation. This is visible in the following ways:
   • An index of such spillovers shows a decrease in the intensity and prevalence of spillovers across sectors.
   • Outsized price rises are barely noticeable to be passed on to core inflation.
   • Important item price rises have little impact on total inflation.

These multiple findings are in line with the well-known notion that inflation persistence is lower in an environment of low inflation, and the inflation rate is susceptible to brief shocks.

In contrast to a high-inflation regime, a low-inflation regime possesses significant self-equilibrating characteristics. Price adjustments in a single industry hardly ever occur together and have a short-lived impact on inflation.

Wages and Prices

The interplay between earnings and prices is the core of the inflation engine. In order for inflation to persist, prices and wages must both chase each other.

• In an environment of low inflation, the response of prices to wages and wages to prices is more muted.
• Wages and prices have a looser correlation when inflation is low. The time it takes for salaries and prices to catch up is significant.

Transitions from Low- to High-inflation Regimes

To comprehend the transitions, one must go deeper into the factors that affect wage and price setting. The motivations and pricing power of labor and corporations determine how much wages and prices match each other. There are three distinct sorts of factors:

I. Structural Forces

These include demography, technology, and political views with regard to how market forces should operate in an economy.

Inflation decreases in tandem with indicators of labor’s pricing power, such as measures of centralization and the intensity of wage negotiations.

II. Cyclical Forces

This is how the overall demand compares against an economy’s capacity for production, i.e., economic slack.

Monetary policy affects economic slack to shift inflation. During transitions, economic slack assumes a significant function.

III. The Evolution of Inflation

This has an impact on incentives and, in turn, price power. It is what makes transitions prone to self-reinforcement.

As it shifts from extremely low levels to higher levels, inflation comes into clear focus. The inflation rates that various agents experience converge as the common component of price changes rises.

As inflation rises, it serves as a more pertinent focus point and coordinating tool for economic agents’ decisions. This encourages them to seek compensation for reductions in their purchasing power or profit margins. Wage-price spirals may result from this, independent of inflation expectations.

Since employees’ and businesses’ inflation expectations are backward-looking, higher inflation leads to increased anticipated inflation. This drives agents to seek compensation for future losses. Once that occurs, the situation will worsen as contracts become shorter and price changes are made more frequently. As inflation rises, initiatives to improve pricing power are launched. These include calls for more centralization of wage formation, price increases, or labor unrest.

In general, rising inflation can cause a psychological shift toward inflation that feeds off itself.

The Operation of a Central Bank’s Monetary Policy in a Low-inflation Regime

Monetary Policy

Monetary policy has always influenced the process of inflation in two ways:

I. Using the Framework’s Characteristics

Objectives, methods, techniques, institutional foundations, and the degree of the central bank’s independence from the government are all relevant characteristics in this context. These characteristics have the largest impact on wage, price formation, and inflation expectations.

II. Through Changes to the Framework’s Policy Position

The framework’s policy position can be changed through such actions as modifying interest rates, balance sheets, and signaling. The position has the most impact on overall demand.

Monetary policy may afford to be more flexible and tolerant to sustained departures of inflation from clearly defined targets in an established low-inflation regime. In such an environment, inflation displays significant self-equilibrating characteristics. Monetary policy appears to lose momentum, and the central bank is prompted to change its policy-adjusting tools more forcefully. As a result, any unfavorable consequences, such as those brought on by interest rates, may be amplified.

The decline in momentum reflects how prices move in an environment of low inflation. It makes sense that monetary policy would affect common price fluctuations more than unique price changes. This is because the common component of price movements is more closely related to aggregate demand. In a low-inflation environment, however, the common component decreases significantly.

A prompt and forceful response to protect price stability is essential given the self-reinforcing nature of transitions from low- to high-inflation regimes. Due to the behavioral changes, their causes, and the potential damage to the central bank’s reputation, leaving a high-inflation regime uncorrected can be extremely expensive. Particularly risky economies are those with a long history of inflation or weak macroeconomic fundamentals. Due to the significant currency depreciations financial markets suffer under such circumstances, changes can be very quick.

The inherent uncertainty of transitions is a problem for central banks. There isn’t an entirely trustworthy real-time indicator. And it’s during transitions that typical models struggle the most. Models are least useful when they are most needed because of the self-reinforcing dynamics and the data on which they must be evaluated. The most accurate indicator is the presence of second-round effects of wage-price spirals. However, the costs of taking corrective action may have significantly increased by the time these effects manifest.

New insights are gained by looking at the inflation engine from the inside. It encourages us to consider the inflation process as two quite distinct regimes with self-reinforcing transitions from low to high inflation regimes. In addition, it offers guidance on how to adjust monetary policy in response to the characteristics of these regimes and the crucial transitions between them, highlighting the importance of a prompt and effective reaction. 

Question

In the past five years, the fictitious country of Macrovia has shifted from a low-inflation regime to a high-inflation regime. Historically, Macrovia has managed to maintain low inflation rates by instituting stringent monetary and fiscal policies. However, recently, due to various geopolitical circumstances, Macrovia is experiencing an inflationary period that is much higher than usual. It has been observed that the spillover of price changes across sectors is more apparent than before. Along with this, significant relative price changes and currency depreciation have been fueling inflation further.

In the context of the changes in inflation dynamics in Macrovia, which of the following statements best describes the primary difference between the country’s past low-inflation regime and its current high-inflation regime?

A. The persistence of aggregate inflation is higher in the high-inflation regime due to enduring individual price changes.

B. The high-inflation regime is more self-stabilizing compared to the low-inflation regime.

C. In the low-inflation regime, price co-movements explain changes in the price index more than concurrent relative price changes.

D. Large price changes in core inflation and volatile components like food and commodities have less influence on inflation in the high-inflation regime.

Solution

The correct answer is A.

In high-inflation regimes, price changes across sectors are more likely to spill over, and the persistence of aggregate inflation tends to increase, in part due to enduring individual price changes. This is the case because high-inflation regimes are not self-equilibrating and are increasingly affected by large relative price changes and currency depreciation, which fuel inflation further.

Choice B is incorrect because it’s the low-inflation regimes that are more self-stabilizing, not high-inflation regimes. Important relative price changes do not last long in low-inflation regimes and do not impact aggregate inflation significantly.

Choice C is incorrect because in a low-inflation regime, changes in the price index are explained more by concurrent relative prices changes, instead of price co-movements. 

Choice D is incorrect because, in a high-inflation regime, large price changes in core inflation and volatile components, like food and commodities, along with currency depreciations, have a greater influence on inflation. In contrast, in a low-inflation regime, the influence of these large price changes on inflation tends to decline.