Next Phase of Inflation Fight Will Be Toughest, BIS tells Central Banks

26 June 2023

By Xavier D’Arcy – FRANKFURT (Econostream) – The Bank for International Settlements said on Sunday that monetary policy still faced a difficult task in getting inflation under control, with the final phase of disinflation likely to prove the most difficult.

In its Annual Economic Report, the BIS warned of significant headwinds and upside risks for the global inflation outlook from labour markets and services.

‘The next phase of disinflation is likely to be more difficult’ for central banks, for which ‘the last mile could prove harder to travel’, according to the report. This was due to the fact that ‘inflation is increasingly driven by the more inertial components, particularly services.’

‘The longer inflation lasts, the more likely it is that households and firms will adjust their behaviour and reinforce it’, the BIS said. ‘Even stronger headwinds may lie ahead’ for the inflation outlook, and the ‘shift in drivers of inflation towards services is likely to increase its persistence’, the report warned.

Meanwhile, recent wage and price developments were increasing the likelihood of persistent second-round effects. ‘While labour’s bargaining power declined significantly over the years of low inflation, recent strikes and calls for unionisation suggest that the environment is evolving’, according to the report. In parallel, there were ‘signs that price-setting behaviour is changing’, with firms ‘adjusting prices more frequently than when inflation was low and stable.’ The ‘shift in drivers of inflation towards services’ was also ‘likely to increase [inflation’s] persistence’.

‘It’s very difficult to discard a scenario where  […] the demands for wage increases by labour are higher than inflation, or tend to be higher than inflation’, BIS General Manager Agustín Carstens said in a briefing with journalists. Wage and price developments could lead to a ‘rebound of inflation, or a more difficult time in bringing inflation down.’

‘Therefore, we perceive that central banks need to be very, very vigilant about this process, because precisely when you enter into a wage-price process it's relatively easy to transit from a low-inflation environment into a higher inflation environment’, he added.

The ‘key question’, according to the BIS, was now ‘whether firms absorb the higher costs or pass them on’. In the latter scenario, ‘inflation could remain uncomfortably high’ due to the fact that firms had ‘rediscovered pricing power’.

The report laid a portion of the blame for the current inflationary episode on overly expansionary policies in recent years. The BIS said that ‘with the benefit of hindsight, it is now clear that the fiscal and monetary policy support was too large, too broad-based and too long-lasting.’ Therefore, policymakers needed ‘to wean growth away from excessive reliance on macro-stabilisation policies’ and normalise monetary and fiscal policy.

The report sought to draw parallels with past inflation surges, with the current rise closely resembling the 1970s, ‘when a “first mile” of disinflation was achieved in the space of about one year but inflation thereafter declined only gradually’, the BIS said. Furthermore, the pace of disinflation so far had ‘been even slower than in the 1970s – although the tightening has proceeded at a faster pace’, pointing to a tougher inflation fight.