With inflation climbing to multi-decade highs and price pressures broadening out, the International Monetary Fund (IMF) has warned that there’s now a “substantial risk” that high inflation becomes a more permanent fixture and that expectations around future rates of inflation could become unmoored and drive a wage-price spiral.
A team of IMF economists said in a recent blog post that central banks in the world’s major economies have, for the most part, been caught by surprise by the intensity and persistence of the current inflationary wave.
“Inflation seemed to be driven by an unusual mix of supply shocks associated with the pandemic and later Russia’s invasion of Ukraine, and it was expected to decline rapidly once these pressures eased,” the economists wrote.
Initially, inflation was more narrowly confined to goods as pandemic lockdowns led people to focus their spending on things like home renovations.
Over time, however, price pressures have broadened out, seeping into a wider array of categories and sticking around for longer.
This, in turn, has led central banks to realize they need to “move more urgently to avoid an unmooring of inflation expectations and damaging their credibility,” the IMF team argued.
Seeking to quell inflationary pressures, the Federal Reserve and other major central banks have embarked on a path of tightening monetary settings. But as evidence builds of economic slowdowns—or outright recessions—in a number of the world’s economies, there’s growing market speculation that central banks will hit pause on further tightenings—or pivot and resume accommodative policies.
A pivot would be a mistake, the IMF team warns, urging central banks to remain “resolute” and keep tightening until inflation drops—along with future expectations—in order to avert “potentially more painful and disruptive adjustments later.”
Inflation Risks ‘Strongly Tilted to The Upside’
The IMF economists believe that the monetary and fiscal tightening should cool demand in goods, while slowing economic growth will take the sting out of price pressures in services. Still, they warn that there remains “substantial uncertainty” about the inflationary outlook.
“Inflation risks appear strongly tilted to the upside. There is a substantial risk that high inflation becomes entrenched, and inflation expectations de-anchor,” they said.
Part of what’s driving this view is that inflation in the services sector—from personal services to housing rents—seems to be accelerating and, according to the IMF, is unlikely to fall quickly.
There’s also the risk of a wage-price spiral unfolding, where expectations around higher rates of inflation stick around for longer, leading workers to demand higher wages to offset the cost-of-living crunch.
“In countries with strong labor markets, nominal wages could start rising rapidly, faster than what firms reasonably could absorb, with the associated increase in unit labor costs passed into prices,” the IMF team wrote.
The IMF team argued that these “second round effects” would lead to “more persistent inflation and rising inflation expectations.”
Another risk is that geopolitical tensions could also intensify, reigniting another round of energy price inflation.
Risk Financial Market Chaos
If upside risks to inflation materialize, central banks will have to act more aggressively to cool the economy, leading to unemployment rising “significantly,” the IMF team said, while warning of potential financial chaos.
“The tightening in financial conditions may well be disorderly, testing the resilience of the financial system and putting especially large strains on emerging markets,” the economists said.
While public support for tighter monetary policy is currently high, this could change if unemployment rises and people experience economic hardship.
But even if public support for further tightening shifts, the IMF argu...