The burst of high inflation in 2021–22: How and why did we get here?

Learn about the possible causes of the unexpected increase in inflation in 2021-2022.

The burst of high inflation in 2021–22: How and why did we get here?
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Summary of the BIS working paper 1060: The burst of high inflation in 2021–22: How and why did we get here?

What is the paper about?

This article discusses four potential reasons why central banks were unable to prevent a surge in inflation in 2021-22. The first reason is that central banks misdiagnosed the nature of economic shocks and therefore implemented overly expansionary policies for too long. The second reason is that central banks disregarded data on inflation expectations due to a strong belief that these expectations were stable. The third reason is that central banks relied too heavily on their past credibility, leading them to underestimate the potential for inflation to rise. The fourth reason is that central banks revised their strategies to be more tolerant of higher inflation due to a trend of falling returns on government bonds, even though returns on private capital remained high.

The Context: 25 Years of Price Stability

  1. The period between 1995 and 2020 saw a prolonged period of price stability in major advanced economies.
  2. This period of stability was a result of successful monetary policy control of inflation, which was more effective than in any previous period.

The First Factor: Shocks and Misdiagnoses

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  1. The pandemic of 2020 caused large economic shocks and justified a significant degree of monetary stimulus.
  2. The economy recovered quickly and the fast recovery led to an increase in inflation, driven by the output gap and an excess of aggregate demand due to fiscal and monetary stimulus.
  3. The second shock, the "delta wave" at the end of 2020, resulted in new lockdowns but had a smaller impact on production due to the private sector's ability to intertemporally substitute production and consumption.
  4. Central banks responded to energy price increases (the third shock) and resulting inflation as a temporary markup shock, relying on anchored inflation expectations, even though such large changes in energy costs could easily unsettle household expectations.

The Second Factor: Expectations

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  1. Inflation expectations were stable and anchored in the decade before 2021.
  2. Central banks were primarily concerned about the possibility of expectations being anchored too low.
  3. Relying on anchored expectations and focusing on downside risk had consequences for monetary policy.
  4. By mid-2021, data showed that expectations were not as anchored as previously believed, with a rising share of households expecting higher inflation and an increase in the standard deviation of expectations.
  5. The shift in the distribution of expectations led to a rise in actual inflation, as well as a rise in the median and average of inflation expectations.

The Third Factor: Credibility

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  1. Central banks are concerned with maintaining credibility by keeping long-term expected inflation close to their target.
  2. In 2021, central banks were able to rely on their credibility, earned from maintaining low inflation for over 20 years, to allow for temporary increases in inflation to offset negative economic shocks.
  3. Financial markets, specifically the 5-year, 5-year forward inflation expected rate, are a key measure of central bank credibility.
  4. However, looking beyond the average of this measure and considering the distribution of expected inflation reveals increasing asymmetry and risk of persistently high inflation.
  5. This shift in the distribution of expected inflation and an increase in the probability of an "inflation disaster" could threaten the central bank's credibility.

The Fourth Factor: R-star and the Tolerance of Inflation

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  1. The "equilibrium real interest rate" or "r-star" is the real interest rate at which savings are equal to investment and output is at its potential.
  2. If the "r-star" is lower, it is more likely that central banks will be unable to lower interest rates aggressively to push up inflation, resulting in too little inflation.
  3. If agents start expecting deflation and the central bank cannot lower interest rates, this can lead to a deflation trap.
  4. To escape a deflation trap, central banks may have to commit to delivering high inflation in the future.
  5. If the "r-star" has fallen, central banks may focus on boosting real activity and providing more stimulus and may be less concerned about supply-side policies and public debt.

So what did we learn?

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In 2021 and 2022, there was a significant increase in inflation. The cause of this increase is likely to be debated for years to come, but this article suggests four potential contributing factors.
First, the large and unusual shocks of 2020 and 2021 were consistently interpreted in a way that justified keeping monetary policy loose, leading to a choice to allow inflation to rise above the target.
Second, a belief that inflation expectations would remain anchored led to an underestimate of the persistence of deviations from the target.
Third, the credibility of monetary policy was over-relied upon, leading to a loss of credibility and an upward spiral of inflation when output rose above potential.
Fourth, estimates of a falling "r-star," or neutral interest rate, led to a focus on stimulating the economy through aggregate demand and a tolerance for inflation above target.
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