Global | Why a new inflation era, not a regime shift, is likely

A shift to a new policy regime with much higher and more volatile inflation is a possibility that can’t be ignored due to its impact on the economy and financial markets. But in our view, if the pandemic triggers lasting effects on the inflation-generation process, a more plausible outcome is a new era of slightly higher inflation within the current central bank inflation targeting regime.

Two distinct eras have characterised the broad inflation targeting policy regime of the past 25 to 30 years. Before the global financial crisis, CPI inflation typically averaged just above 2% in most advanced economies, and central bank policy rates went up as well as down. In the post GFC era, inflation has been lower and less volatile, despite ultra-accommodative monetary policy.

The shift in eras reflected two broad developments. First, factors such as a savings glut, austerity, and a lack of conventional monetary policy space created a period of deficient demand, dampening inflationary pressures.

Second, other developments weakened the upward push on inflation from stronger activity in the domestic economy. Central banks’ previous successes in anchoring inflation reduced expectations of higher inflation during bursts of demand. Globalisation and automation also helped to lessen cost pressures, while various labour market development helped to keep wage pressures well contained.

Many of these inflation-taming factors are still firmly in place. But others have either lessened or even reversed, albeit perhaps only temporarily (Figure 1). This suggests a new era could have begun in which central banks may find it easier to meet their inflation targets. We think well-anchored but somewhat higher and more volatile, inflation is likely, and in due course will prompt a modest normalisation of policy rates.