The global spike in inflation after the pandemic has led to vigorous debate on how quickly central banks will bring it down to target. However, no one really seems to worry about a repeat in the foreseeable future; market expectations of long-term inflation have largely come into line with central bank targets across advanced economies. And no wonder; Stantcheva (2024) finds that the US public deeply dislikes inflation even though most individuals have only a tenuous grasp of what economists mean by it. True, there has been some discussion of allowing inflation to settle at a higher rate of, say, 3%. This discussion predates the pandemic and largely centres around the question of whether the monetary authorities will ultimately decide they require a higher inflation target to cushion against the zero lower bound on interest rates that constrained central banks during the 2010s and into the pandemic. The ability of central banks to make their targets credible, however, is generally taken for granted.
In Afrouzi et al. (2024b), we take a different view, arguing that the political economy environment in which central banks operate has changed markedly after the pandemic. In particular, factors that for decades had made it easier to maintain low average inflation, including globalisation, demographics, and fiscal restraint, may have gone into reverse. If so, this could reawaken a dormant inflationary bias that markets and researchers had considered eradicated by the advent of central bank independence and inflation targeting. Our view does not necessarily imply a world where inflation is always above target. Rather, it would be one where it is more difficult for central banks to battle democratically elected politicians who realise that the public dislikes higher unemployment, lower social spending, and higher taxes as much as it dislikes inflation. Whereas most central banks have great operational independence over the short run – and public criticism of them can backfire as Demiralp (2024) shows – over the long run, politicians control appointments, budgets, and, in many cases, the central bank’s mandate. Thus, our paper challenges the ‘end of history’ narrative of modern central banking which views inflation as a largely solved technocratic problem.
We are not the first to make such a suggestion. A widely discussed book by Goodhart and Pradhan (2020) argued that persistent structural changes in the global economy will keep future global inflation higher on average than in the past, although they do not offer an analytical framework for explaining why central banks would not simply contract monetary policy as necessary to achieve their inflation targets. Rogoff (2003) anticipates their analysis by arguing that central bankers had the wind at their backs during the period of globalisation and more conservative fiscal policies. However, the static Barro and Gordon style model he employed required making ad-hoc assumptions about why globalisation might lower political economy pressures, and indeed did not include any real explanation of why long-run inflation itself mattered for economic activity.
Our 2024 paper, which offers a much-simplified version of Afrouzi et al. (2023), aims to resolve these issues, and importantly offers a fully dynamic analysis. We reach several novel conclusions relative to both existing political economy models of monetary policy and the extremely large modern literature on New Keynesian models. First, central banks’ temptation to inflate comes from their concern for raising output and employment in the short run given monopoly distortions in the economy; this does not have to be an expressed concern of central bankers but rather can be transmitted through political pressures that interact with economic pressures. Second, inflation itself is problematic because, in a dynamic New Keynesian model, higher inflation creates greater price disparities across firms who, unlike in the classical models of Milton Friedman and others, do not all coordinate on resetting prices and wages at the same time. These price disparities lead to misallocation and inefficiency in the economy.
From a technical perspective, our analysis is quite novel in that we solve our model analytically without having to linearise around zero inflation as is the ubiquitous practice in the academic literature. We show that the framework can be visualised as a simple diagram with long-run aggregate demand and supply curves, with an intersection point corresponding to steady-state inflation and output, as displayed in Figure 1. The framework captures that although money is neutral in the New Keynesian model (a one-time monetary shock has no real effects), it is not ‘super-neutral’: the steady-state level of inflation affects the steady-state level of real output. The cost of higher inflation via price dispersion may be relatively modest if inflation only rises from 2% to 3% in the baseline model, though Afrouzi et al. (2024a) provide an analysis that suggests this cost is non-trivial in a model with production networks. Moreover, if one considers inflationary pressures as emerging via occasional (if rare) bursts of much higher inflation, then the average costs of the ensuing distortions are much greater.
Figure 1 Illustration of supply shock in long-run aggregate supply/long-run aggregate demand framework
Another interesting result we can demonstrate in the non-linear model is inflation overshooting, as depicted in Figure 1. When contractionary supply shifts lead to a higher average steady-state level of inflation, the short- and medium-term rates of inflation can be expected to substantially overshoot the long-term rate. This means that even if median inflation remains at 2%, concern over such bursts can imply higher long-term interest rates (including say for mortgages and car loans) even in normal times.
We recognise that our theoretical model implies predictions that are very different from the consensus discussed at the outset of this piece. Although we cannot formally test the model, our paper does revisit the disinflationary period of the 1980s through 2010s that occurred throughout the world, albeit with different timing across countries and country groups; see Figure 2.
Figure 2 Inflation across the world
Source: Afrouzi et al. (2024b) based on data from Ha et al. (2021).
In our paper, we describe how changes in globalisation, market liberalisation, fiscal policy, and unionisation helped support disinflation over much of this period. Many of these factors—which worked in tandem with the expansion of central bank independence over this period—may be reversing today. We also note that the era of a zero lower bound on interest rates may have masked inflationary tendencies for an extended period, precisely because central banks lacked an effective instrument for inflating. Now, with some arguing that a considerable portion of the recent rise in long-term real interest rates is a return to trend (Rogoff et al. 2022, 2024) and with the experience of the pandemic that chastised bond markets, the zero lower bound may be a less frequent crutch for anti-inflation credibility in the future.
We believe that higher average inflation is not inevitable, and that if governments choose to strengthen the independence of central banks sufficiently, they will be able to resist the political pressures. Despite the considerable progress of the past couple decades, as Romelli (2024) documents, further such progress appears unlikely in most countries given rising populism, not to mention enormous budgetary pressures from rising defence needs, the green transition, and servicing today’s very high debt levels. Thus, even if central banks do eventually get inflation back to target this round, the inexorable rise in political economy pressures implies that occasional bouts of inflation are likely to be a bigger risk than bouts of deflation in the coming decade, with overshooting and volatility becoming the new normal. If not contained, then, as Braggion et al. (2023) show, the effects may be felt for generations.
References
Afrouzi, H, M Halac, K S Rogoff and P Yared (2023), “Monetary Policy without Commitment”, NBER Working Paper 31207.
Afrouzi, H, S Bhattarai and E Wu (2024a), “The Welfare Cost of Inflation in Production Networks”, Working Paper.
Afrouzi, H, M Halac, K S Rogoff and P Yared (2024b), “Changing Central Bank Pressures and Inflation”, NBER Working Paper 32308.
Braggion, F, F von Meyerinck, N Schaub and M Weber (2023), “The long-term effects of inflation on inflation expectations”, VoxEU.org, 13 September.
Demiralp, S (2024), “Silence is Golden: How Public Criticism of Central Banks can Backfire for Leaders”, VoxEU.org, 18 April.
Goodhart, C and M Pradhan (2020), The Great Demographic Reversal: Aging Societies, Waning Inequality, and an Inflation Revival, London: Palgrave-MacMillan.
Ha, Jongrim, M Ayhan Kose and F Ohnsorge (2021), “One-Stop Source: A Global Database of Inflation”, World Bank Policy Research Working Paper 9737.
Rogoff, K (2003), “Globalization and Global Disinflation”, Federal Reserve Bank of Kansas City Economic Review 88, no. Q IV: 45-78.
Rogoff, K, B Rossi and P Schmelzing (2022), “Was the post-global financial crisis collapse in real interest rates secular?”, VoxEU.org, 24 October.
Rogoff, K, B Rossi and P Schmelzing (2024), “Long-Run Trends in Long-Maturity Real Rates 1311-2022”, American Economic Review, forthcoming.
Romelli, D (2024), “Recent Trends in Central Bank Independence”, VoxEU.org, 26 February.
Stantcheva, S (2024), “Why do We Dislike Inflation?”, Working Paper, Harvard University.
