The Next Inflationary Surge
After reaching its highest level in decades in mid2022, inflation in the United States and the eurozone fell sharply over the second half of last year. But, in December, the headline consumer price index (CPI) in the US and the Harmonized Index of Consumer Prices (HICP) in the eurozone rose slightly. Was it an aftershock or a foreshock?
The speed of last year’s disinflation surprised many, not least central banks, which have insisted that it is too early to claim victory. But are they urging caution because they believe that there is persistent underlying inflationary pressure – which might explain the recent uptick – or are they simply acknowledging uncertainty?
Markets seem to be embracing the latter explanation, anticipating that both the US Federal Reserve and the European Central Bank will start cutting interest rates in the spring. This sentiment is not unfounded: if we consider the six-month annual percentage change in core inflation – a timelier indicator of underlying inflation than the 12-month change – both the US and the eurozone have brought inflation back down to their 2% target. The evidence points to a persistent decline, regardless of the recent (small) increase in headline figures.
This means that price stability may well have been reestablished within three years, which by most definitions would make the latest bout of inflation “transitory.” But let us not get caught up in the rather pedantic debate between those who argued that inflation would be short-lived and those who anticipated that it would be “persistent.” Instead, we should seek to understand the mechanisms that pushed inflation up and then down, in order to draw lessons for responding to future price volatility.
Monetary policy is a powerful tool; it can always bring inflation down eventually. And central banks are often encouraged to get to work right away: if they do not intervene quickly and firmly, the logic goes, inflation expectations might become “unanchored,” fueling a wage-price spiral that leads to employment losses. This was the story of the 1970s.
But aggressive disinflation carries costs, and reining