The inflation rate increases over the past three years followed a unique disruption to the global economy.

The pandemic lockdowns in 2020 initially tilted demand away from services and toward goods. However, unprecedented fiscal and monetary stimulus raised demand. Unfortunately, many firms could not ramp up production fast enough, resulting in mismatches between supply and demand and rising prices in some sectors.

For example, ports were stretched beyond their capacity, partly due to pandemic-related staffing shortages, so the demand for goods rose, resulting in growing backorders. When economies reopened, demand for services came roaring back, and Russia’s invasion of Ukraine sent commodity prices soaring, pushing global inflation to its highest level since the early 1970s.

To understand the recent global inflation surge, there’s a need to delve beyond traditional macroeconomic aggregates. Our modelling shows how inflation spikes in specific sectors became embedded in core inflation, a less volatile measure that excludes food and energy. The interaction between soaring demand and sector-specific bottlenecks and shocks is key to our analysis. These caused large shifts in relative prices that resulted in an unusual dispersion of prices.

When supply bottlenecks became widespread and interacted with strong demand, the Phillips curve, the main gauge of the relationship between inflation and economic slack, steepened and shifted upwards. The steeper Phillips curve implied that relatively small changes in economic slack could have a large effect on inflation. That came with bad news and good news.

The bad news is that inflation surged as many sectors hit capacity constraints. The good news is that it was possible to curb inflation at a lower cost in terms of lost economic output.

This last insight leads us to the new lesson widespread supply bottlenecks can present central banks with a favourable trade-off when confronting a demand surge. Because the Philips curve becomes steeper in such cases, policy tightening can be particularly effective at rapidly bringing down inflation with limited output costs.

However, when bottlenecks are confined to specific sectors with relatively flexible prices, such as commodities, we are reminded of an old lesson: the common practice of focusing monetary policy on core inflation measures remains appropriate. Excessive policy tightening in such cases can be counterproductive, leading to costly economic contraction and resource misallocation.

Given these insights, central bank monetary policy frameworks should identify the conditions under which front-loaded tightening is appropriate. This requires enhanced models and better sectoral data to gauge underlying inflationary forces, improve forecasts, and guide the fine-tuning of policy responses. A first step in the right direction may involve collecting more frequent data for prices by sector and supply constraints to determine if key sectors are bumping against supply bottlenecks. Also, understanding structural factors, such as how different sectors set prices and the links between them, would provide additional valuable insights.

Several central banks plan to review their policy frameworks in the coming months. These reviews present an opportunity to incorporate well-defined escape clauses in their frameworks to tackle inflationary pressures when aggregate Phillips curves steepen. Forward guidance should internalise those escape clauses and allow for front-loading or tightening.

Such added flexibility should allow central banks to be better prepared in the future and help safeguard their hard-earned credibility.

For feedback and further information, kindly contact [email protected]

Subscribe to our market intelligence notes for updates. Thank you.