Most of the world is battling the fire of inflation. Last year’s debate was over whether the price pressure is transient or not. Now very few people believe that inflation will go away on its own. The big question being asked today is whether central banks have done enough to contain inflation. Financial markets are betting on the possibility that inflation is at its peak in several major economies.
The historical record shows that inflation rises rapidly but takes its own sweet time to return from its peak to its target. In other words, deflation can last longer than previous increases in inflation. In a recent paper three economists look at the actual record over the past three decades. Andrés Blanco, Pablo Otanello, Tereza Ranosova present the empirical evidence after the large inflation boom, and what it means for policymakers (The Dynamics of Large Inflation Surge, NBER Working Paper 30555).
Blanco, Otanello and Ranosova define inflationary growth in two ways. First, episodes of high inflation in the right side of the distribution, or above the 90th percentile. The threshold beyond which they describe an increase in inflation as growth is 2.1 percentage points. The average of 112 such episodes of increase in inflation since 1990 is 3.8 percentage points.
Second, a lot also depends on the inflation characteristics of individual countries. An increase in inflation from 2% to 4% in one country is quite different from a similar increase in inflation from 8% to 10% in another country. Three economists look at each country’s inflationary experience to define inflationary growth when price pressures increase by more than 1.65 standard deviations over the past 10 years. They identify 65 episodes using this definition.
There are three broad lessons to be learned from the study of inflation growth. First, deflation is a slower process than the initial increase in inflation. The average duration of inflation growth is either 1.5 years or 1.1 years, depending on which of the two definitions of inflationary growth is used. On the other hand, the average duration of post-deflation is 4.4 years or 3.2 years. This means that the deflation process is, on average, about three times longer than the growth of inflation.
Second, inflationary growth generally outpaces inflation expectations in the short term. One-year forward inflation forecast errors—or the difference between actual inflation and past inflation expectations—make inflation rise by 4.3 percentage points in the first year of growth, and then return to its pre-growth levels after two years. She goes away. Inflation expectations for the coming five years have risen lower but remain more consistent, rising 0.3 percentage points but stuck there through the deflation process.
Third, Blanco, Otanello and Ranosova showed that nominal interest rates increase by an average of 2.6 percentage points following an increase in inflation and remain high through post-deflation. However, real interest rates calculated from one-year forward inflation forecasts do not rise much through either an inflationary or deflationary process. This is amazing result. No major shortfall in the fiscal balance has also been observed.
There is no doubt that what most large economies are experiencing today is a surge of inflation that will take time to end. Inflation expectations are also rising as a result of the price shock. However, when the two criteria suggested by Blanco, Otanello and Ranosova for defining inflation growth are applied to different countries, it is clear that the picture is more nuanced at the individual country level. What follows is a quick analysis of the inflation situation in India and the US.
The US faces a far more serious inflationary challenge than India. Average annual inflation in the US is 2.48%. It is expected to be 8.05% for 2022 or 6.19 percent above its average level for the last 10 years. In the case of India the situation is different. Average inflation in 2022 is expected to be 6.89%, or 1.08 percent above its 10-year average. Additionally, if we use the range of 1.65 standard deviations to examine the records in these two countries, the current increase in Indian inflation does not qualify as inflationary growth, whereas the price situation in the US certainly does. Is.
This does not mean that we should be optimistic about the inflation situation in India. Inflation has remained above the upper limit of the formal inflation target for 21 out of the 31 months since January 2020, and the Monetary Policy Committee is preparing to draft its mandated letter to the government to state that it will be doing three Why has inflation failed to meet the target? consecutive quarters. However, the calibration of monetary policy response may need to be different from countries such as the US.
The broader global lesson is that even though we accept the optimistic view that inflation is peaking in many countries, the process of deflation in financial markets may be slower than many expect.
Niranjan Rajadhyaksha is CEO and Senior Fellow at Earth India Research Advisors, and a member of the Academic Advisory Board of the Meghnad Desai Academy of Economics.
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