The recent inflation resurgence is challenging central banks. The annual inflation rate in the US has been reported at 6.8%, which is the highest in 40 years. If this inflation remains only for the short term, it can be counterproductive to control it aggressively. Any tightening of monetary policy without a strong reason can raise the short-term interest rates. It can delay recovery from the downturn caused by the recent pandemic.
This recent surge is not higher than what was seen in the 70s and early 80s. The inflation then was caused mainly because of oil price surges. The present inflation, when compared to the 2000s, is still a big shock. The main reason behind the current inflation is the recent pandemic that has disrupted worldwide supply chains. Shortages of inputs like semiconductors have affected the productions of vehicles and electronic goods. Consumer demand is recovering after coming out of the pandemic, but suppliers are unable to meet the demand. Shortages of freight capacity and shipping containers have only worsened the problem. The transportation costs for the suppliers have increased significantly. Energy prices are under pressure. Major economies are seeing labor shortages, forcing companies to pay higher compensations to attract new staff.
How should central banks respond to this inflation challenge? Businesses and consumers have some expectations. They think it will remain at high levels in the same way it was in the 70s. Inflation can continue if these views are incorporated in the wage claims. One difference compared to the 70s and 80s is that the current labor market is more flexible. Private sector trade unions today do not have the bargaining power they had during those years. The direction inflation takes will also depend on how fast supply disruptions are controlled and managed in the coming months.
One way to check if the inflation will remain transitory is by checking the predictions for the inflation data and labor market. If inflation starts coming down by mid-2022, central banks can increase the rates slowly to meet the expectations.