IMF says central banks likely to prevent inflation

IMF says central banks likely to prevent inflation

U.S. dollars and other world currencies are in a charity receptacle at Pearson International Airport in Toronto.

Recent interest rate hikes by central banks are likely to prevent inflation expectations from becoming established, according to new research by the International Monetary Fund.

The Fund said in an analytical chapter released on Wednesday from the IMF's forthcoming World Economic Outlook, wage and price hike dynamics in 2020 and 2021 were driven by highly unusual COVID 19 pandemic shocks, unlike previous episodes that reacted to more conventional economic forces.

The IMF researchers looked at 22 episodes of high inflation and falling real wages in advanced economies over the past 50 years and found most subsided quickly.

Production capacity and labor supply shocks drove the hikes over the past two years, while prices were driven up largely due to private savings and the release of pent-up demand, according to the International Monetary Fund.

The IMF said that past inflationary episodes usually ended as nominal wages slowly caught up with prices over several quarters, avoiding an upward spiral. This happened when economic shocks were viewed as temporary, leading wages and prices to stabilize based on normal labor supply dynamics.

The chapter noted a few key exceptions, including the US stagflation era that followed the 1973 OPEC oil embargo, when nominal wages failed to increase with prices and further oil shocks in 1979 kept inflation high and real wages falling. This trajectory changed only when the Federal Reserve raised interest rates sharply, leading to years of recession in the early 1980s.

Indexing wages to cost-of-living increases in Belgium also helped fuel a major wage-price spiral there in the 1970s, with wage inflation sometimes exceeding price gains, the IMF said.

The end of World War Two rationing in the United States resulted in massive demand for scarce consumer goods, fuelling double-digit wage and price gains for years until industry is fully adapted to peacetime production and excess demand by 1949.

The historical evidence suggests that episodes characterized by about a year of accelerating prices and wages have not generally lasted, with nominal wage growth and price inflation settling on average after several quarters, according to the International Monetary Fund.

The current environment may be reassuring, but the IMF said there is a risk of prolonged price and wage inflation if inflation expectations are backwards looking, anticipating that past conditions, such as the price dynamics of 2021, will continue into the future even if there are new price shocks.

When wage and price expectations are more backward-looking, monetary policy actions need to be front-loaded to minimize the risks of inflation de-anchoring, the Fund said, backing its call for central banks to push ahead with rate hikes to fight inflation.

When the World Bank and IMF hold annual meetings in Washington next week, inflation is expected to be a key topic.