The Real Inflation Culprits

Daniel Gros is Director of the Institute for European Policy-Making at Bocconi University.

SOFIA – Advanced-economy central bankers seem to have earned their summer vacation. With a series of sharp interest-rate hikes, they appear to have beaten back a wave of inflation that, according to the conventional wisdom, was caused by an unprecedented combination of negative shocks. But before we praise central bankers for taming inflation, we should consider their role in causing it.

The most commonly cited factor driving the recent surge in inflation is high energy prices, which soared after Russia’s full-scale invasion of Ukraine, owing to fears that Western sanctions would prevent Russian hydrocarbons from reaching markets. But, by early 2023, crude oil prices had fallen back to pre-invasion levels.

More important, the 2022 spike was not exceptional. Oil prices have increased at comparable speeds and reached similar peaks before, such as in 2008 and 2011-12. But neither of those episodes brought a noticeable surge in the price level. Even in Europe, where the increase in natural-gas prices after the invasion was indeed unprecedented, energy prices returned to pre-war levels well before inflation began to fall.

No central banker has yet acknowledged the well-founded doubt that last year’s energy-price shock caused the surge in non-energy prices. What central bankers have done is to point to a second culprit: supply-chain disruptions.

But here, too, the shock in question was temporary. The Federal Reserve Bank of New York’s composite indicator of global supply-chain pressures shows that there was an unprecedented increase in 2022; but by early 2023, the index was back in normal territory. Today, it is in negative territory, indicating that supply chains are running particularly smoothly.

Most macroeconomic models – not to mention common sense – indicate that a temporary supply shock should cause a similarly temporary increase in the price level. This means that, if recent inflation had been caused by the two supply shocks of 2022, it would have initially risen above the canonical 2% target, then fallen below it as the shocks faded. This is not the case in the United States or in the eurozone: stripping out the impact of falling energy prices, inflation continues to run at about 4-5%.

One could, of course, argue that asymmetries could cause overall prices to behave differently when energy prices rise and fall. But it is not clear what the relevant asymmetries would be in this particular episode. Workers have accepted a reduction in real wages, despite tight labor markets. And while there might be a need for some prices to fall when energy prices do, there is no sign that downward rigidity of nominal prices or wages currently plays any role.

So, why has inflation persisted? One likely reason is that we are seeing the delayed effects of past monetary policy. In 2020 and 2021, when the global economy was being ravaged by the pandemic, central banks began purchasing huge amounts of assets. During the first few months of 2020, the policy served a clear purpose: to stabilize financial markets. But even after that goal was achieved, central banks continued to buy up assets.

At this point, central bankers were motivated by fear of deflation. But while inflation had fallen in 2020-21, this was mainly due to a short-lived drop in energy prices. Simply put, policymakers’ decision to continue massive asset purchases was an overreaction to a temporary shock.

Nobody should be surprised that this policy had inflationary consequences, or that they took time to materialize. As Milton Friedman explained, monetary policy affects the economy with “long and variable lags.” Assuming a lag of 12-24 months, central banks’ pandemic asset purchases would have begun affecting inflation by the end of 2021, with the most powerful effects coming in 2022-23 – a time of notable labor-market tightness. The state of the labor market would explain why pandemic monetary policy did more to fuel core inflation than did the previous wave of unconventional monetary policy, in 2015-18.

It is difficult to know precisely how much blame for current inflation can be attributed to pandemic asset purchases. But, based on the European Central Bank’s own assessment of its 2015-18 policy, one might conclude that the purchases contributed a couple of percentage points. So, if the US Federal Reserve and the ECB had ended their asset purchases once financial markets were stabilized in early 2020, core inflation today might be in the region of 3%, rather than 5%.

To be sure, the large fiscal-support packages enacted during the pandemic probably also contributed to inflation, especially in the US. But that does not let monetary policymakers off the hook. On the contrary, while American and European central bankers might prefer to focus on their progress in tamping down inflation, there is no use pretending that they did not play a significant role in creating the problem.