This is part of a series, ‘Economists Exchange’, featuring conversations between top FT commentators and leading economists
The Bank for International Settlements is known as the central bankers’ bank. It does provide banking services for the world’s central banks, but more importantly uses its convening powers to provide a forum for discussing monetary and financial stability.
With inflation hitting multi-decade highs across both advanced and emerging economies, the BIS’s view that nations are taking a big risk with inflation staying high for much longer than hoped, hit the headlines earlier in the summer.
General manager Agustín Carstens said that instead of thinking that inflation could smoothly rise and fall, it was more likely to stick either in a favourable world of low-inflation around central bank targets of 2 per cent or in a dangerously high zone.
In this discussion he explains his thinking that inflation could get stuck too high for a long time and what is needed to avoid it. Part of the medicine is for the public to experience rapidly rising prices, realising that they are something to be avoided almost at all costs.
Chris Giles: Tell us about your idea that countries can live either in low-inflation or high-inflation worlds.
Agustín Carstens: I think it’s very important [to note] that the function of inflation is not necessarily that obvious. At the end of the day, the definition of inflation is an overall increase in the price level. That gives the impression that all prices are moving at the same time, at the same pace, and the reality is that that never happens.
Usually, when you have a low-inflation regime, what you see mostly is relative price changes [some prices going up and others coming down], and these shape production and consumption decisions. These do not give you particular information about the overall pressures of inflation.
But if, at some point, you start seeing that more prices are rising and that those rises tend to be more persistent, that means individual price changes carry more information. That starts a process where firms start revising their prices more often, and feeds back into different loops. Cost gets affected, labour markets start responding. And instead of stabilising, high inflation becomes self-reinforcing.
CG: If we could just stay with the low-inflation regime for now, what does this regime allow central banks, companies and households to do? Why is this such a nice world to live in?
AC: First of all, you can disregard inflation. You can be inattentive of inflation. You have one less thing to worry about.
CG: Presumably, companies can make longer-term decisions or lock in longer-term contracts as well.
AC: Absolutely. The issues that affect the outcome of your decisions, in a way, are more in your control, are more in your own environment. They have more to do with your own sector, more to do with what your market is. Of course, there are general market conditions to worry about, but if you really don’t have to worry about the value of money in the future, that’s huge.
That translates into a relatively flat Phillips curve, which gives [central banks] a little bit more leeway to implement active monetary policy to respond to the business cycle without fearing that the consequence will be immediate or very quick inflation. Therefore, that enhances the stabilisation role of monetary policy, as we saw during the last 10 to 15 years.
CG: So, if you’re in a stable low-inflation world, the central bank can, for example, look through oil price changes if they’re of a reasonable size and relatively shortlived.
AC: Absolutely, and that happens even in emerging markets. I have a lot of experience in Mexico, and of course there it was very difficult to deal with double digit inflation. But if the people understand that this is a transitory change, that allows you not to force an adjustment in other prices that have not been affected.
CG: Now tell us about the high-inflation world. How is that different, and how do then people behave in a world of persistently high inflation? And how high does inflation have to get to be in this world?
AC: I guess for advanced economies, something higher than 5 per cent is already high, and in emerging markets, probably 7 per cent is the floor.
I think the main issue is that it forces you as a firm and also as a labourer to be far more aware about your pricing decisions. And you have to really think about whether and when you are going to adjust prices, and by what amount?
If, for example, you’re in a low-inflation environment, you take those decisions based on a relatively long horizon because they’re conditions that you can anticipate, and you can optimise. Whereas when you have high inflation, you are observing multiple shifts and therefore you have to start deciding how are you going to adjust your price. Certainly, it means that you will adjust prices with more frequency and, or by higher amounts.
CG: And presumably, in the high-inflation world, ultimately wages need to follow prices higher as well, so there’s a wage price spiral.
AC: Yes. A key aspect here is that indexation and wage agreements are not revised so often, but at some point, the future arrives and then they start kicking in, and that can give a new boost into inflation. And I believe, in some economies, we are starting to see that.
If there are more co-ordinated negotiations, if there is an indexation process, as the labour settlements respond more to the overall conditions of inflation rather than to focus really on the sector, then it’s when you start getting a more entrenched, I would say, inflationary dynamic.
CG: What is the evidence that we are seeing this inflationary dynamic?
AC: I think that financial conditions are that impulse why everyday demand has been sustained. So, that gives an additional impetus to the individual price changes. And that has come with a combination of very salient prices increasing. It is this combination that is giving you the increasing price as well.
CG: Yes, why did we get here?
AC: More than anything, the business cycle changed in a very dramatic way, in a very short period of time.
In 2020, we were fearing deflation and a major depression. And governments said let’s use all the instruments we have to mitigate the impact, let’s flatten the curve of mortality of firms, let’s get the economy going. Now, we were surprised in the first instance by a very quick recovery, and that had to do with the vaccination.
And that brought us into a dynamic that started to feel like inflation was getting traction, but then this process was supported, again, by the commodity shock that resulted from the Russian invasion.
Monetary policy doesn’t have the nimbleness to adjust itself quickly with the business cycles, and that’s also something we need to take into account into the future.
CG: How sure are you that we are now in this high-inflation world? Would you diagnose that to have happened in many countries, or is it a risk that it will happen?
AC: I think that the warning lights have been blinking, and what I feel relatively comfortable [with] is that the policy response has been swift. I think once there was a conviction that we were not dealing with a few relative price changes, the response has been strong.
And therefore, I think this provides the opportunity for these very high inflation levels not to be entrenched. Some inflation expectations are being revised downwards, and also expectations in some markets which have a lot of inflation, that the policy tightening that we need in the future will not be so tight. So, I think the response has been opportune, and it’s still early, but so far, I think, so good.
CG: If we’re talking about a transition back to a low-inflation world, how difficult is that? When we’ve got strong demand in many parts of the world, at least in excess to supply capacity, does this mean that you need to create more than a downturn?
AC: We will necessarily see a slowdown. As a matter of fact, it’s a desired slowdown in the short term, because that will establish the conditions for much better growth in the medium term. And I think the key aspect that will really determine how deep the economy could go down, is the nexus between the real sector and the financial sector.
So far, markets have adjusted relatively well. Yes, there have been some important valuation corrections, but markets are behaving well, and their mediation process is going fine. So, I’m not anticipating a major collapse in the financial markets. If this were to happen, then the impact on aggregate demand would be stronger, and that would probably bring inflation down faster, but from an output point of view.
A positive thing is that we have started this from a point of strength in the financial markets. I think that will give resilience to the process. We also have, as you said, a quite active economy, very high employment, so that should keep resilience.
But yes, needless to say that some slowdown will happen, will need to happen. I still think that we can pull this off without a major slowdown in the real sector.
CG: And what are you looking for? What will be a sign of success in terms of re-embedding a low-inflation environment?
AC: I think a very important sign would be, for example, if the percentage of different goods and services that are producing positive changes suddenly starts decreasing. Because then, you start seeing that the overall component of inflation is coming down, and relative price changes are starting to kick in back again.
So, to have that metric I think is very important. In your CPI, you can have the analysis to sectors. If you see that 90 per cent of the sectors have positive increase in prices, and now it’s 85 per cent and then it’s 70 per cent, and then you get back to normal, I think that starts giving you signals.
And it’s also important for the central banks to enhance the information there. I think it’s very important to let people know what is happening with those prices, and show them that the adjustment process, the way you anticipate it, is taking place.
At the end of the day, with the tightening of monetary policy, you want firms and price centres to say, if I increase prices today and the monetary policy is tightening, I might have a real increase in my price. That might affect my demand, and therefore I better fix down my price adjustments.
CG: Is it therefore useful occasionally, every few decades or so, to have an inflationary period, so that people understand actually what inflation is and realise that it’s a bad thing?
AC: I understand your point, not that I like it. But at the end of the day, central banks have to show their contribution to society, not only by providing money, but by providing money that preserves its value.
And to have an institution in the state, with the unique or the primary objective to keep price stability, people need to appreciate the consequences of not having price stability.
If you have never experienced inflation, then the central bank has a mandate that it might be very good in writing, but we haven’t seen it in action. So, the public interest of the central bank is huge, and therefore to test the ability of the central bank is important, so that the central bank can show what it delivers for society. I think that’s key.
The above transcript has been edited for brevity and clarity.