Only a new policy regime can stop rampant inflation, but don’t count on it yet

CENTRAL banks’ assumption that expansionary monetary and fiscal policies could coexist with low inflation has been shattered. Inflation has accelerated and is unlikely to return to the low and stable levels that prevailed in the past three decades. As a result, the US Federal Reserve and other central banks face what we call the “Great Paradox of Monetary Tranquillity”.

Stimulative macroeconomic policies have fuelled inflation but there is a more fundamental explanation for why a major regime shift is underway. People are more likely to anticipate inflation will be higher in the future because past and prospective monetary and fiscal policies warrant such expectations. We call this an accommodative, pro-inflationary, long-term trend in monetary and fiscal policy, and the long-term recollection of these policies has contributed to shaping long-term inflation expectations.

This long-term inflationary trend may have gone unnoticed because, for some years, inflation was subdued even as inflationary policies were being implemented. As the former gradually picks up, the normal, positive correlation between accommodative policy, consumer prices and inflation expectations is being restored.