The burst of high inflation in 2021–22: how and why did we get here?

Summary

Focus 

The current institutional arrangements for monetary policy delivered more than two decades of low and stable inflation. Yet central banks failed to prevent the burst of high inflation in 2021–22. When inflation started to rise in the first half of 2021, many central banks dismissed it as a normal catchup of the price level after its sharp fall during the pandemic. Some even welcomed the return of inflation after many years when it was stubbornly stuck below target. But the initial correction in the price level became a persistent acceleration. In April 2022, the one-year inflation rate was 9.0%, 6.3%, and 7.5% in the United Kingdom, the United States and the euro zone, respectively.

Contribution 

This paper inspects four tentative hypotheses for why central banks failed to prevent this burst of high inflation. The first is a misdiagnosis of the nature of shocks during a time of great uncertainty, leading to an overly long period of expansionary policy. The second is a neglect of expectations data, driven by a strong belief that inflation expectations were firmly anchored and that inflation increases would thus be temporary. The third is an overreliance on the credibility earned in the past, creating an illusion of too much room to focus on the recovery of real activity and underpredicting the resulting inflation. The fourth is a revision of strategy that made central banks tolerant of higher inflation because of the trend fall in the return on government bonds, even though the return on private capital stayed high.

Findings 

Inflation rose because central banks allowed it to rise. Rather than highlighting isolated mistakes in judgment, this paper points instead to underlying forces that created a tolerance for inflation that persisted even after the deviation from target became large. These factors suggest reforms for the future. For now, facing the challenge of bringing down inflation, they suggest that policies in the near term may involve (i) accepting lower levels of real activity in the future; (ii) acting vigorously and sharply in the near future by raising interest rates to re-anchor expectations; (iii) re-stating as loudly and convincingly as possible the primacy of price stability as the goal that guides policy; and (iv) revising upwards the relative costs of high inflation while re-focusing on aggregate supply policies.

Abstract

The current institutional arrangements for monetary policy delivered more than two decades of low and stable inflation. Yet, central banks failed to prevent a burst of high inflation in 2021-22. This paper inspects four tentative hypotheses for why this happened. The first is a misdiagnosis of the nature of shocks during a time of great uncertainty leading to an overly long period of expansionary policy. The second is a neglect of expectations data driven by a strong belief that inflation expectations were firmly anchored and so inflation increases would be temporary. The third is an over-reliance on the credibility earned in the past, creating an illusion of too much room to focus on the recovery of real activity and underpredicting the resulting inflation. The fourth is a revision of strategy that made central banks tolerant of higher inflation because of the trend fall in the return on government bonds, even though the return on private capital stayed high.

JEL classification: E58, E50, E31

Keywords: Price level, central bank independence, r-star, dove, hawk

• Discussion by Signe Krogstrup 
• Discussion by Federico Sturzenegger