Introduction
The recent remarkable surge in inflation after its long quiescence has raised
pressing questions about the dynamics of inflation more generally. In the process, it
has put the spotlight on the importance of sector-specific developments including
the persistent pandemic-induced shift from services to goods; sectoral bottlenecks
in global value chains; and soaring food and energy prices (see Chapter I).
An
urgent question is whether higher inflation will become entrenched.
These developments have underscored the need to go beyond the aggregate
dynamics of inflation in order to shed further light on how its engine works, ie to
look “under the hood”.
What does this mean, concretely? Many workhorse models of inflation build on
a Phillips curve relationship between inflation and economic activity. Taking this
approach, inflation fluctuations reflect aggregate demand pressures on productive
capacity, temporary supply shocks and changes in inflation expectations. Looking
under the hood complements this perspective. It distinguishes clearly between a
multitude of relative price changes and underlying inflation itself. It examines in
detail how, and under which conditions, such relative price changes can morph into
broader-based inflation. And it pays close attention to the wage-price formation
process – the core of the inflation engine – illuminating how this depends on the
rate of inflation itself and how it is linked to inflation perceptions and expectations.
This also means going beyond the well known cyclical drivers of inflation to examine
the structural influences on wage- and price-setting. These are often global in nature.
The distinction between relative price changes and underlying inflation is
critical. Relative price changes reflect those in individual items, all else equal. This
may or may not be related to underlying inflation, ie a broader-based and largely
synchronous increase in the prices of goods and services that erodes the value of
money and devalues the “unit of account” over time.
Key takeaways
• To better understand inflation, it is key to go beyond aggregate analysis in order to separate relative
from generalised price changes and examine their joint dynamics.
• Periods of high and low inflation are very different, notably with respect to their self-stabilising
properties and how firms and workers respond to relative price shifts.
• Preserving a low inflation environment is paramount and requires ensuring that relative price
changes do not translate into entrenched inflation. Transitions from low- to high-inflation regimes
are especially challenging because they tend to be self-reinforcing.
• Monetary policy has an essential role to play in ensuring the durability of a low-inflation regime
through the features of its operating framework as well as through flexible and timely adjustments
in the policy stance.
42 BIS Annual Economic Report 2022
Looking under the hood reveals some important features of the inflation process.
Low-inflation regimes turn out to be very different from high-inflation
ones.1
When inflation settles at a low level, it mainly reflects changes in sector-specific
prices and exhibits certain self-equilibrating properties. Changes in inflation become
less sensitive to relative price shocks, and wage and price dynamics are less closely
linked. Moreover, there is evidence that the impact of changes in the monetary
policy stance becomes less powerful.
Transitions from low- to high-inflation regimes tend to be self-reinforcing. As
inflation rises, it naturally becomes more of a focal point for agents and induces
behavioural changes that tend to entrench it, notably by influencing wage and price
dynamics. This puts a premium on better understanding how transitions work in
order to be able to identify them early enough as events unfold. The transition from
a low- to a high-inflation regime in the late 1960s and early 1970s illustrates some
of the possible forces at play. These include large and persistent relative price
increases – notably oil – in a context of strong cyclical demand and in an environment
structurally conducive to wage-price spirals, ie high pricing power of labour and
firms coupled with the loss of the monetary anchor provided by the Bretton Woods
system.
Monetary policy plays a key role in establishing and hardwiring a low-inflation
regime and in avoiding transitions to a high-inflation one. Once a low-inflation
regime is established, monetary policy can afford to be more flexible and tolerate
more persistent, if moderate, deviations of inflation from targets. Having gained
precious credibility, it can reap the benefits. At the same time, monetary policy must
ensure that the regime is not jeopardised.
It is one thing to tolerate moderate
deviations from point targets; it is quite another to put the system’s self-equilibrating
properties to the test. The costs of bringing inflation back under control can be very
high. Calibrating policy to prevent transitions is especially challenging.
This chapter examines inflation in depth, from an under the hood perspective.
It starts by defining inflation and characterising its behaviour as a function of its
level, drawing on the disaggregated price data that underpin it. It then provides a
systematic analysis of wage- and price-setting behaviour and of how changes in
relative prices can give rise to inflation, facilitating transitions across regimes.
Finally, it explores the key role of monetary policy in securing a low-inflation regime
and preventing transitions to a high-inflation one.