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University of Basel

Fear. (01/2022)

Is inflation here to stay?

Text: Sarah Lein

After a long period of tranquility, inflation began to rise again last year. The reasons for this increase are manifold. What can halt this development.

Time and time again, inflation is confused with high prices — but it actually refers to the rate at which the price level is increasing. For example, if a price goes up from CHF 10 to CHF 15 over a year and then stays put, the rate of inflation is 50 percent in the first year and 0 percent thereafter. Even if the higher price becomes permanent, the inflation is only temporary. In other words, high inflation means that prices are rising strongly and persistently over time.

Inflation is determined by three factors

First, there are what are known as “supply shocks,” where prices are driven up by a shortage of certain goods, leading to higher inflation and a higher cost of living. Recent examples of this include the rise in oil prices in 2021, which has led to higher production and transport costs and therefore higher prices for goods. This trend has been further exacerbated by the war in Ukraine. Bottlenecks and disruption to supply chains have also resulted in price rises.

Second, there is a cyclical component. In an economic boom, demand rises faster than supply, causing prices to rise more quickly. Incidentally, the opposite effect is seen in recessions, where demand falls faster than the rate at which supply can be reduced. This results in an excess supply that leads to lower or even negative inflation (deflation).

The third factor are the inflation expectations of firms and households. These expectations are relevant because prices and wages are not typically adjusted day-to-day, but rather for longer periods of time — and the expectations also have an impact on prices and wages set for that time period. When companies come to set their prices, they look at factors such as expected changes in their production costs and in the prices charged by their competitors. Pay negotiations are also influenced by expectations of how sharply inflation will reduce purchasing power during the period wages will be set for. Expectations about inflation in the future thus influence prices and wages set today, which therefore determine inflation today.

What is the role of the central bank?

The role of the central bank is to ensure price stability. When prices increase in response to supply shocks caused by a pandemic or war, there is little that the central bank can do to directly address these shocks. The only way it can tackle the situation is by addressing cyclical components and expectations of inflation. When it comes to the former, the central bank can lower demand for goods and services (and therefore the economy as a whole) by raising interest rates, for example — but the underlying relationship is relatively complex and indirect. Higher interest rates make loans more expensive and therefore investments less attractive. When interest rates are higher, people also save more and therefore consume less.

Furthermore, the domestic currency appreciates, reducing demand for export goods. The dampening effect on demand should cause a decline in inflation, but the process is difficult to control. This is because demand doesn’t always respond to the same extent to changes in interest rates. Furthermore, it often takes a long time for the impact of interest rate hikes to be reflected in demand and ultimately in inflation. Recent studies also show that demand would have to be squeezed fairly hard in order to bring inflation down.

In an open economy such as that of Switzerland, the exchange rate offers a more direct way of influencing inflation. Given that about a quarter of the goods and services consumed in Switzerland are imported, import prices make up a substantial proportion of all prices in households’ consumption baskets. If the Swiss National Bank (SNB) allows the Swiss franc to appreciate vis-a-vis other currencies, there will be a relatively rapid and direct fall in the price of imported goods, thereby reducing inflation in Switzerland.

Probably the biggest influence that the central bank can have on inflation is via inflation expectations. As the central bank’s aim is to keep inflation low (at a target value that it defines itself, between 0 percent and 2 percent in Switzerland), it must be able to convince firms and households that it actually does its job. Let us assume that everyone is convinced that the central bank will return inflation to the target value should it ever get too high. In that case, even if firms raise the prices of their products in response to recently higher energy costs, for example, they will refrain from making further preemptive price increases. This is because they expect inflation to fall again in the future. If all companies act accordingly, although there may temporarily be higher rates of inflation due to energy price increases, this situation will not be permanent. Indeed, inflation would return to the target value even if energy prices remained just as high but didn’t continue to rise.

As a negative counterexample, let us assume that the companies do not trust the central bank to do its job and that they instead expect higher inflation this year to result in higher inflation next year as well. They will preemptively build this expectation into their prices, so that the expectation of higher inflation practically becomes a self-fulfilling prophecy.

This shows how important it is for the central bank not only to pursue its objectives credibly and consistently, but also to make clear that it will — and does — take action when necessary. This credibility serves to anchor inflation expectations to the target value. Successful monetary policy is therefore manifested above all in stable and low inflation expectations. According to the (unfortunately rather sparse) data we can observe, so far, neither the euro area nor Switzerland have seen any significant increases in these expectations, which is a good sign. The USA, on the other hand, has recently seen some slight increases after a prolonged period of higher inflation — and these increases require firm action on the part of the central bank.

Is inflation coming back?

The danger of permanent inflation lurks not only in rising energy prices and shortages of goods due to bottlenecks in global value chains but also, above all, in an un-anchoring of inflation expectations — which can be shaken by prolonged periods of high inflation. Should that happen, even if a higher rate of inflation was actually due to temporary supply shocks, it could be seen as persistent and would have an impact on wage and price setting, therefore becoming a more permanent situation. Whether this happens or not depends on how credibly central banks pursue their objective of price stability and whether they also take action when they perceive this objective to be at risk. By doing so, it’s possible to prevent ongoing inflation from becoming a self-fulfilling prophecy.

This article was written at the start of March 2022.

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