Lessons from a century of inflation shocks

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Inflation will take longer to tame than most people think, but taming it doesn’t necessarily mean much higher unemployment, and premature loosening of monetary policy could be dangerous.

Those are the main conclusions from a new IMF working paper published on Friday, which examined lessons from over 100 separate inflation shocks on 56 countries since the 1970s.

Given its obvious timeliness we’re surprised the paper hasn’t caused more of a stir already, but Alphaville suspects it will provide ammunition to a lot of central bank hawks at an interesting juncture for monetary policy.

Here’s the tl;dr from economists Anil Ari, Carlos Mulas-Granados, Victor Mylonas, Lev Ratnovski and Wei Zhao:

We document that only in 60 percent of the episodes was inflation brought back down (or “resolved”) within 5 years, and that even in these “successful” cases resolving inflation took, on average, over 3 years. Success rates were lower and resolution times longer for episodes induced by terms-of-trade shocks during the 1973—79 oil crises. Most unresolved episodes involved “premature celebrations”, where inflation declined initially, only to plateau at an elevated level or re-accelerate. Сountries that resolved inflation had tighter monetary policy that was maintained more consistently over time, lower nominal wage growth, and less currency depreciation, compared to unresolved cases. Successful disinflations were associated with short-term output losses, but not with larger output, employment, or real wage losses over a 5-year horizon, potentially indicating the value of policy credibility and macroeconomic stability.

These are the abridged conclusions from seven “stylised facts” that the IMF economists drew from their data work. You can read the full paper here, but here are our quick summaries of them.

Fact 1

Inflation is persistent, especially after terms-of-trade shocks

It’s easy to think that inflation shocks caused by a sudden explosion in energy or food prices will dissipate once the fundamental cause (embargoes, wars, bad weather etc) fades.

But inflation only returned to pre-shock levels after a year in 12 out of the 111 inflationary episodes that the IMF examined, and in most of those cases it only happened because of a massive economic shock like the 2007-08 financial crisis or the Asian financial crisis of 1997-98. In other words they were not examples of “immaculate disinflation”.

In 47 episodes examined, inflation still hadn’t returned to normal after five years, and for the balance the average time it took to bring inflation back to pre-shock levels was three years.

Fact 2

Most unresolved inflation episodes involved ‘premature celebrations’

This argument seems particularly pertinent today. In almost all the stubborn inflation shock cases inflation dropped “materially” in the first three years, only to plateau at a high level or to reaccelerate.

The IMF suggests that this was likely caused by premature monetary policy easing or governments loosening the purse strings too early.

Fact 3

Countries that DID Defeat inflation had tighter monetary policy

One of the IMF’s main findings was that successful resolution of inflation shocks tended to come when central banks raised interest rates to combat it, whatever its cause:

The difference in monetary policy tightening between countries that resolved versus those that did not resolve inflation is statistically significant, quantitatively large, and established consistently across different measures of the stance. On average, countries that resolved inflation raised their effective real short-term interest rate by about 1 percentage point compared to the pre-shock stance, while the real rate in countries that did not resolve inflation was 4.5 percentage points lower on average compared to pre-shock.

Fact 4

Countries that resolved inflation KEPT AT IT

The corollary to facts 2 and 3 is that successful inflation fights usually came when central banks both raised interest rates higher and kept them high for longer (plus governments had restrictive fiscal policies). D’oh.

Fact 5

Countries that resolved inflation SUFFERED LIMITED FX depreciation

Another [annoyed grunt] point, to be honest. Countries that successfully beat down inflation (through higher-for-longer interest rates) were either able to maintain their currency pegs or limit their currency’s depreciation.

Fact 6

Countries that resolved inflation had lower nominal wage growth

As you’d expect, countries with tighter monetary and fiscal policy saw more moderate wage growth, while countries that didn’t saw accelerating wage growth — but mostly only in nominal terms.

In real terms, countries that managed to defeat inflation only saw marginally less earnings growth destruction over time.

The IMF cautions that the difference is too small to be statistically significant, and could be skewed by a smaller sample size (wage growth data isn’t good for the full sample). But it’s interesting that the difference is pretty modest.

Fact 7

Countries that BEAT inflation didn’t experience lower growth or higher unemployment

This is the paper’s most interesting finding. You’d assume that aggressive monetary and/or fiscal policy tightening would impose a heavy economic toll. But instead:

Over the 5-year horizon, we find no statistically significant difference in growth outcomes between countries that resolved inflation and those that did not. While inflation shocks reduce growth and increase unemployment regardless of whether they are resolved or not, the mean and median output declines are marginally larger for unresolved episodes over the medium-term.

So what does this mean? How relevant is this historical exercise to today’s problems? It’s hard to say.

It’s telling that well over half of the episodes the IMF examines were caused by the 1973-79 oil crisis. As Isabella Weber et al have written, energy is along with food one of the most “systemic” components of inflation.

But the recent spurt of inflation was at least partly initially triggered by supply-chain bottlenecks caused by the pandemic, then stoked by a demand shock as people went on a post-pandemic shopping spree and most recently by Russia invading Ukraine.

So history might be a bad guide to today’s situation. But some central bank officials are definitely going to read this as evidence of how they should go higher and stay restrictive for longer.