An inflation process in flux: BIS Quarterly Review

• New study shows that price changes in narrowly defined sectors account for most of the fluctuations in consumer price inflation, indicating that the recent rise in inflation is likely to be transitory.
• The study also finds that in an environment of sector-specific price changes, monetary policy is limited in its ability to steer inflation within tight ranges, putting a premium on flexibility in pursuing inflation targets.
• Financial markets sent mixed signals in the period under review, with some developments pointing to an upbeat outlook while others indicated unease.

In a regime of low and stable inflation, most of the fluctuations in headline inflation are due to price swings in finely defined expenditure categories rather than to generalised price movements, according to a new study released today in the Quarterly Review of the Bank for International Settlements (BIS). These changes tend to have only a transitory impact of inflation, which is thus more likely to remain range- bound.

The special feature, "Monetary policy, relative prices and inflation control: flexibility born out of success", by Claudio Borio, Piti Disyatat, Dora Xia and Egon Zakrajšek, examines the change in inflation dynamics since the mid-1980s and provides additional evidence indicating that the recent surge in inflation is probably short-lived.

The study also finds that changes in the stance of monetary policy affect a narrow set of prices, most of which are in the service sector. This limits the ability of monetary policy to fine-tune inflation within a specified range. The authors argue that these findings put a premium on flexibility in pursuing tightly defined inflation targets: central banks can afford to be more tolerant of deviations from targets, which over time will tend to self-correct.

As central banks look ahead to the next stage of the recovery from a shock like no other, getting on top of the details of the inflation process is key to understanding what is around the corner.

Hyun Song Shin, Economic Adviser and Head of Research

The traditional chapter on recent financial market developments¹ includes two boxes: on the booming demand for investment products with environmental, social and governance benefits; and on the dynamics of European money market fund flows during the March 2020 turbulence.

According to the Quarterly Review, risky assets registered continued gains, even as downside risks to growth and the prospect of tighter US monetary policy challenged financial markets.

The persistent buoyancy in equity and corporate credit markets underpinned exceptionally accommodative financial conditions in many advanced economies, particularly the United States.

By contrast, government bond yields declined in advanced economies, even as investors perceived an increased likelihood of monetary policy tightening. Challenges to emerging market economies surfaced in the form of currency weakness and portfolio outflows despite declining long-term US yields.

Financial markets are giving us mixed signals. The rich valuations of risky assets point to investors' continued willingness to bet on a strong economic recovery, but the recent flattening of the yield curve in advanced economies and various financial headwinds in emerging markets appear to indicate a certain unease about the outlook.

Claudio Borio, Head of the Monetary and Economic Department

Three features analyse investment, Covid policy measures and banking:

• Giulio Cornelli, Sebastian Doerr, Lavinia Franco and Jon Frost analyse the rapid rise in equity funding for financial technology (fintech) firms. The authors find that investment in fintechs has been higher in countries with more capacity for innovation and better regulations. Venture capital funding for early-stage fintechs rises after merger and acquisition activity by large banks, but not after that by big techs.
• Catherine Casanova, Bryan Hardy and Mert Onen examine policy measures implemented in response to the pandemic in order to support bank lending. The authors find that these measures enhanced banks' balance sheet capacity and provided effective incentives for banks to use that capacity. Small and medium-sized enterprises, particularly in sectors hard-hit by the pandemic, seemed to benefit from guarantee programmes.
• Robert McCauley, Patrick McGuire and Philip Wooldridge provide a sweeping history of international banking, making use of the BIS international banking statistics. The authors draw attention to regulatory arbitrage, financial liberalisation and financial innovation as the primary drivers of the multi- decade expansion of international banking, which peaked at over 60% of world GDP before the Great Financial Crisis. Crisis-related losses and regulatory reforms subsequently constrained banks' expansion and accelerated the rise of non-bank financial institutions as international creditors.

¹ 1 December 2020 to 22 February 2021.