Top central bankers admit inflation models fell short

The analytical tools central banks use to understand inflation contain flaws that may have limited their usefulness in tracking surging prices over the past year, senior officials said today (June 29).

Jerome Powell, chair of the US Federal Reserve, said the Phillips curve that sits at the heart of many central bank models was “just not capable” of producing high inflation predictions.

“I think we now understand better how little we understand about inflation,” Powell said, speaking at the European Central Bank’s (ECB) annual research conference in Sintra.

The Phillips curve – which relates unemployment and inflation – was flat in most advanced economies in recent years, as inflation had been subdued despite low unemployment. Such an assumption may no longer be a useful guide.

Agustín Carstens, general manager of the Bank for International Settlements, said his institution had also been caught out by the sudden change in inflation dynamics. He pointed out an audience member who was the BIS economist tasked with producing inflation scenarios in the 2021 annual economic report – “he had a hard time cranking out higher numbers”, said Carstens.

The 2022 BIS annual economic report, published on June 26, urges central banks to “go beyond” the Phillips curve. The report notes the curve ignores sectoral developments and assumes changes in relative prices have only a transitory impact on inflation. It also ignores structural factors that may be shifting beneath the surface.

Carstens said many factors were at play that traditional models have struggled to capture, such as the process of expectation formation and the balance of bargaining power in the labour market. These forces can generate non-linearities.

A key problem for macroeconomics has been its focus on aggregate demand, Carstens added. Central banks have a good understanding of how their policies generate changes in demand which then feed into the price level. Aggregate supply, however, is treated “as given”.

The world is now facing an inflationary shock that is driven mostly by the supply side. The Russian invasion of Ukraine has driven up commodity prices at a time when supply chains were already struggling to adjust to a surge of demand as economies recover from Covid-19. In the UK, Brexit has added further disruption.

Christine Lagarde, president of the ECB, noted not just aggregate supply but patterns of supply across sectors could have an impact on inflation.

She alluded to a session earlier in the day when Şebnem Kalemli-Özcan, a professor of economics at the University of Maryland in the US, presented work comparing recent eurozone inflation to other countries. The paper shows inflation tends to be higher in the presence of sector-specific labour shortages. Overall, foreign shocks and supply chain bottlenecks have played an “outsized role” in European inflation.

Powell echoed the other panellists concerns about supply-side analysis. “What did we get wrong?” he asked, suggesting the answer was “looking at supply-side issues and believing they would be resolved relatively quickly”.

Consumer price index inflation is now 8.1% in the eurozone and 8.6% in the US. Lagarde acknowledged inflation would likely not return to the ECB’s 2% inflation target for at least three years.

Bank of England governor Andrew Bailey added that many structural factors were affecting inflation in ways that could last beyond the resolution of current supply problems. The pandemic has left a “legacy” in labour markets, while the war in Ukraine has impacted the “European security situation”. Climate change is also “affecting our world” and could prove inflationary, Bailey said.

Powell said the Fed’s view was the world would likely return to a “blend” of current circumstances and pre-Covid patterns. He acknowledged a risk that the world could fragment along geopolitical lines, which would likely raise costs.

Lagarde said changes seemed permanent to her. She highlighted changing patterns of globalisation and also mentioned climate change. “I don’t think we are going to go back to that environment of low inflation,” she said.