Inflation is falling. But the days of only 2% price growth may never return | Bot To News


For the first time in decades, people in Europe and North America had to deal with the dire consequences of rapid inflation. That means higher grocery bills, paychecks that don’t stretch as far, and savings that lose value. For some, it meant choosing between heating their homes and putting food on the table.

There are signs of relief in these major advanced economies. Prices are still rising, but at a slower pace as aggressive interest rate hikes dampen activity. Energy prices retreat on fears of a global recession, and the price of shipping a container across the ocean has fallen. These factors reduce inflationary pressures. (In the United States, consumer prices rose at a 7.1% annual rate in November, the slowest increase since December 2021.)

But even if this burst of inflation has peaked, economists warn that the world may not return to simpler days when prices didn’t rise at all. Indeed, keeping inflation close to 2% — the goal of central banks from the US Federal Reserve to the European Central Bank and the Bank of England — will not be easy.

An aging population, the climate crisis, the transition to green energy, and a shift away from global supply chains to greater local production could drive up prices in the coming years. That could mean policymakers need to keep interest rates higher.

“A decade after the financial crisis, they have struggled mightily to raise inflation,” said Mark Zandi, chief economist at Moody’s Analytics. “In the coming decade, they will fight hard to reduce inflation.”

In the 38 member countries of the Organization for Economic Co-operation and Development, which represent most of the major economies, annual inflation is expected to fall from 9.4% in 2022 to 6.5% next year and to 5.1% in 2024.

The diminishing impact of the pandemic and lower oil prices are partly responsible for the drop, but it is mostly due to an unprecedented campaign by central banks to steer inflation back down.

Borrowing costs have been raised rapidly in recent months to slow demand, causing the economy to cool. Much uncertainty remains: Central banks aren’t quite sure how high they need to raise interest rates – and how long they need to keep them there – to get inflation close to 2%. But they expect the effort to pay off in the end.

“It will take several years before inflation returns to the Fed’s 2 percent target,” Cleveland Federal Reserve President Loretta Mester said in October. “But I expect significant progress over the next year.”

However, the final percentage point of excess inflation could prove particularly difficult to eradicate. As inflation declines and the economic costs of higher interest rates become more apparent in rising unemployment, central banks will face calls for easing. 3% inflation may start to look more tolerable if unemployment is painfully high.

“I suspect that when inflation falls back to 3% in 2023 or 2024, there will be an intense debate about whether it is worth reducing it to 2% at the cost of a further significant slowdown in activity,” Olivier Blanchard, former chief economist of the International money fund, he wrote in a recent column in the Financial Times.

Fighting inflation for the foreseeable future is one thing. But there are also broader trends reshaping politics, society and the economy that could support prices, including demographic changes, the drive to replace fossil fuels with clean energy and deglobalization.

“Inflation could reach 2%, but will it stay there?” said Manoj Pradhan, founder of Talking Head Macroeconomics. “All of these risks become structural stories that I think pave the way for inflation to stay higher than it has been.”

In North America and Europe, according to the United Nations, almost one in five people are currently 65 or older. This proportion could grow to one in four people by 2050. That means spending will have to increase on services like health care and pension payments, says Pradhan, who published research on the issue.

At the same time, the labor force is expected to shrink in many advanced economies – a dynamic that is already evident after the pandemic. Early retirements and long-term illnesses have reduced participation in the workplace in countries such as the United States and the United Kingdom. Together, this will create more debt and stock prices.

People shop on Oxford Street in London, England on December 3, 2022.

“You’re not going to have the same flow into the labor market that you used to,” said Randall Kroszner, who served as Federal Reserve governor from 2006 to 2009. “I see that as one of the biggest challenges.”

The consequences of global warming — and the essential task of weaning the world off oil, gas and coal — must also be considered. In a speech earlier this year, ECB policymaker Isabel Schnabel outlined three risks.

The first, which she called “climate inflation,” refers to the actual costs of climate change as extreme weather and more intense and frequent natural disasters disrupt food and housing production. The second, “fossilflation,” is the “legacy” of the costs of fossil fuel dependence, leaving the world exposed to spikes in energy prices due to events such as Russia’s war in Ukraine.

Then there’s “green inflation,” fueled by rising demand for renewable energy and products like electric vehicles. At least for now, supply of critical minerals can’t keep up, which could push prices up at times.

In addition, the pandemic and the war in Ukraine have accelerated efforts to transform supply chains so that products are closer to customers, especially for sensitive technologies — a big change from how companies have thought about manufacturing for the past three decades.

Geopolitical instability is prompting global companies to reduce their reliance on China, which benefited from an export boom in the early 2000s as companies sought to take advantage of the country’s abundance and cheap labor.

“Deglobalization creates an unequivocal upside risk to inflation,” Pradhan said, noting that while it may boost economic output in countries like the United States, higher costs will have to be passed on somewhere.

It is not clear how much inflation these factors will cause. It could be less than one percentage point or more, depending on which economist you ask. But there is consensus that inflation could become stickier and therefore more difficult to control.

“It is possible that longer-term changes — such as those related to labor supply, deglobalization and climate change — could reduce the elasticity of supply and increase inflation volatility in the future,” Fed Vice Chairman Lael Brainard acknowledged in a speech last month.

Here comes the hard question: If 2% inflation is going to be harder to achieve, does it make sense for central banks to keep it as a target and consequently encourage them to hold on to higher interest rates?

This is not a topic that central banks are eager to discuss now. It would be one thing to raise the target when inflation is not an issue – but doing so at this point could send a message that central banks are not in the driver role. This is dangerous because their credibility is key to taming inflationary expectations.

“This would make it more difficult to rein in inflation, [and] this would weaken economic growth due to greater uncertainty about long-term inflation,” said Michael Saunders, a former Bank of England official. “I want to emphasize that this would be a really bad idea.”

But Blanchard, a long-time advocate of a higher target, thinks advanced economies should consider a 3 percent inflation target to ease pressure on central bankers.

While there are concerns that raising the target could encourage workers to keep asking for pay rises, research shows that people pay attention only when inflation rises above the 3 to 4 percent range, he noted.

Former Fed governor Kroszner believes it would be “problematic” to adjust the target in the current environment, although he said it is “something central banks should always think about.”

“The 2% target chosen by the central banks of most countries is arbitrary,” he added.

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