Is it true that the surge in inflation we’re currently seeing in the US and Europe will only be temporary, as the Fed and the ECB claim?

At the moment, we can observe a substantial rise in inflation rates in many countries.  The main drivers of these increases are probably the continuous upward revisions to our economic growth forecasts, combined with significant supply bottlenecks, for example in the semiconductor industry and the transportation sector. For this reason, many people fear that high inflation rates may be here to stay for the foreseeable future. Let’s take a closer look at the arguments for and against a long-term rise in inflation rates.

Long-term inflation expectations are key

How the prices will develop depends to a large extent on the kinds of price hikes that companies and households expect to see in the future.  If everyone expects that the inflation rate will climb to five percent, employees will demand five-percent pay raises, and companies will try to bump up their prices by five percent as well. This leads to a wage-price spiral. The consequence of such a spiral is that the high inflation expectations actually become a reality. For this reason, keeping inflation expectations at a moderate level of around two percent is an important goal for almost all central banks.

What factors may lead to higher long-term inflation expectations?

First, people may lose confidence that the central banks will in fact change their expansionary monetary policies and raise interest rates if there are signs that inflation rates are picking up momentum. For example, central banks may be reluctant to change course because they fear that such steps may threaten the stability of the financial system. Second, the central banks may face political pressure urging them to tolerate higher inflation rates so that inflation “eats up” part of countries’ rising public debt. Third, the COVID-19 stimulus packages may cause the economy to overheat.

Why inflation expectations are likely to remain at lower levels

The high inflation rates we’re currently seeing are primarily caused by temporary effects (economic rebound, supply shortages, phaseout of temporary VAT reductions, etc.). These effects will disappear soon. Medium-term forecasts indicate that economic growth rates are bound to slow down again. Political pressure on central banks to continue on a path of expansionary monetary policy has eased somewhat, partly also due to the recent change in the White House. The Fed already announced in June that interest rate hikes are to be expected for the year 2023. This has caused interest rates on government bonds to go down, which is evidence that investors have revised their inflation expectations downward.

Investors’ long-term inflation expectations can be determined directly by looking at certain financial contracts, e.g. inflation swaps. What we see is that the average five-year inflation rate expectation in five years’ time is slightly above 1.5% for the euro area. These moderate inflation rate expectations likely mean that there won’t be a wage-price spiral and that the current inflation rates will soon fall to lower levels again. 

Josef Zechner, Professor at the Institute for Finance, Banking und Insurance