The world’s rich economies have only completed the easy part of restraining inflation and it will be the “last mile” that could be the hardest to travel, the Bank for International Settlements said in its annual economic statement.
Known colloquially as the central banks’ central bank, the BIS detailed why inflation may be stickier than expected – particularly if authorities don’t stay the course.
First, the good news
Inflation appears to have peaked in 2022 in most nations and has been “falling quite notably in most cases”.
About 95% of central banks have responded by hiking interest rates since early 2021 in “the most synchronised and intense monetary policy tightening in decades”, the BIS said. The ratio exceeded the 80% proportion of coordinated action during the oil price shocks of the 1970s.
And in dealing with risks of bank collapses – such as Silicon Valley Bank in the US and Credit Suisse in the Switzerland – authorities had “responded forcefully to contain contagion and deployed a number of crisis management tools to curb systemic risks”.
Now, for the hard part
Despite the positive results so far, the BIS warns that “even stronger headwinds may lie ahead”, with “a material risk of further financial stress” as economies slow.
While inflation may have moderated, it remained too high, the BIS said in language that has peppered the Reserve Bank’s statements for months.
Indeed, the “last mile” to cover on the disinflation journey may prove to be much tougher than the distance travelled so far.
Goods and services that soared in price because of supply shocks (such as Covid and Russia’s invasion of Ukraine) mostly haven’t come down, with impacts spilling over into other sectors.
And the longer inflation stays high, the more we all become inured to it, slowing its decline.
“Households and firms may adjust to persistently higher inflation by trying to recoup previous losses and then seeking to avoid future expected ones through their wage- and price-setting decisions,” the BIS said.
Beware of similarities
And prices aren’t just rising – the increases are becoming more uniform. According to the BIS, a little-known gauge – the similarity index – has spiked in the past year.
“Differences in consumption patterns across consumers and input costs across firms matter relatively less, so that the general price level becomes more relevant for individual decisions.”
When the index is high, so is the probability that inflation in the next period will be at least as high as in the current one, the BIS said.
The similarity index turns out to be novel for the Australian Competition and Consumer Commission. The competition watchdog does monitor some industries for collusive behaviour, such as firms selling relatively undifferentiated products. (Fuel is one, with diesel down by 10% in the March quarter, for instance).
Still, the study of diminishing difference might not be so narcissistic when it comes to prices.
Households v businesses
The BIS said governments can do their bit in bringing down inflation – such as restraining or even placing temporary caps on spiky price increases – but how fast inflation retreats may well hinge on a wages-versus-profits battle.
The RBA has lately cottoned on, too. In the minutes of its June rates meeting, members noted both workers and firms were observed to be indexing their prices to past inflation.
“These developments created an increased risk that high inflation would be persistent, which would make it more difficult to keep the economy on the narrow path,” it said.
During periods of low inflation over the past two decades, feedback between wages and price increases had been low, the BIS said. That could change, though, as workers push for higher wages to make for past inflation or what they expect to come.
Businesses, too, are trying to adjust prices to account for increased costs, including wages. So far, the BIS notes, corporate profits “have held up remarkably well”, departing from norms during previous inflation bouts.
“In past episodes, profit growth tended to fluctuate within a comparatively narrow range around zero,” the BIS report said.
“One concern is that, having been able to raise prices more easily than in the low-inflation regime, firms are now more reluctant to accept profit squeezes and will pass on cost pressures to prices more readily.”
Those in the RBA might underscore “reluctant” and stress it is the actual behaviour of firms that matters. The central bank hasn’t seen cause to change its view that strong demand in the economy is what has kept up profits – rather than the gouging of consumers.
The May statement on monetary policy also noted the broad-based spread of inflation, a concept akin to the similarity index. More things are now displaying high inflation currently than a year ago, is how the RBA sees it.
Pat Bustamante, a senior economist at Westpac Business, says demand needs to fall and labour market conditions need to ease for inflation to become less sticky.
“Businesses will be less inclined to increase prices if demand falls sharply – they only increase prices because they can get away with it when demand is strong,” Bustamante said. “If labour market conditions ease and there are more people looking for work, workers may be less inclined to ask for big wage increases.”
The other circuit breaker will be to increase supply through improved productivity. That needs time and politicians leading a pro-productivity agenda, “given governments are preoccupied with today’s economic hardships”, he said.
