At the Front Lines of the Inflation Fight, Uncertainty Reigns

on Jul1
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When prices started to take off in multiple countries around the world about two years ago, the word most often associated with inflation was “transitory.” Today, the word is “persistence.”

That was uttered repeatedly at the 10th annual conference of the European Central Bank this week in Sintra, Portugal.

“It’s been surprising that inflation has been this persistent,” Jerome H. Powell, the chair of the Federal Reserve, said.

“We have to be as persistent as inflation is persistent,” Christine Lagarde, the president of the European Central Bank, said.

The tone of the conference was set on Monday night by Gita Gopinath, the first deputy managing director of the International Monetary Fund. In her speech, she said there was an “uncomfortable truth” that policymakers needed to hear. “Inflation is taking too long to get back to target.”

And so, she said, interest rates should be at levels that restrict the economy until core inflation is on a downward path. But Ms. Gopinath had another unsettling message to share: The world will probably face more shocks, more frequently.

“There is a substantial risk that the more volatile supply shocks of the pandemic era will persist,” she said. Countries cutting global supply chains to shift production home or to existing trade partners would raise production costs. And they would be more vulnerable to future shocks because their concentrated production would give them less flexibility.

The conversations in Sintra kept coming back to all the things economists don’t know, and the list was long: Inflation expectations are hard to decipher; energy markets are opaque; the speed that monetary policy affects the economy seems to be slowing; and there’s little guidance on how people and companies will react to large successive economic shocks.

There were also plenty of mea culpas about the inaccuracy of past inflation forecasts.

“Our understanding of inflation expectations is not a precise one,” Mr. Powell said. “The longer inflation remains high, the more risk there is that inflation will become entrenched in the economy. So the passage of time is not our friend here.”

Economists have been writing new economic models, trying to respond quickly to the fact that central banks have consistently underestimated inflation. But to some extent the damage has already been done, and among some policymakers there is a growing lack of trust in the forecasts.

The fact that central bankers in the eurozone have agreed to be “data dependent” — making policy decisions based on the data available at each meeting, and not take predetermined actions — shows that “we don’t trust models enough now to base our decision, at least mostly, on the models,” said Pierre Wunsch, a member of the E.C.B.’s Governing Council and the head of Belgium’s central bank. “And that’s because we have been surprised for a year and a half.”

Given all that central bankers do not know, the dominant mood at the conference was the need for a tough stance on inflation, with higher interest rates for longer. But not everyone agreed.

Some argued that past rate increases would be enough to bring down inflation, and further increases would inflict unnecessary pain on businesses and households. But central bankers might feel compelled to act more aggressively to ward off attacks on their reputation and credibility, a vocal minority argued.

“The odds are that they have already done too much,” said Erik Nielsen, an economist at UniCredit, said of the European Central Bank. This is probably happening because of the diminishing faith in forecasts, he said, which is putting the focus on past inflation data.

“That’s like driving a car and somebody painted your front screen so you can’t look forward,” he said. “You can only look through the back window to see what inflation was last month. That probably ends with you in the ditch.”

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