Following more than thirty years of low inflation, advanced economies saw a surge in inflation driven by an unprecedented concomitance of factors linked to the Covid-19 pandemic and the Russian invasion of Ukraine. Central banks around the globe have responded with a sharp tightening of monetary policy.

The debate over the drivers of elevated core inflation can be split into two broad interpretations: (i) de-anchoring of inflation expectations and a possible profit and wage spiral, which calls for a tighter monetary policy stance; or (ii) a reflection of the relative price adjustments needed for efficient resource reallocation in response to a series of asymmetric shocks, suggesting a more accommodative stance is desirable.

This report takes stock of what has happened, including the monetary policy response in the euro area and the US, and discusses the challenges ahead.

The authors show that supply chain disruptions and demand changes induced by the pandemic and the increase in commodity prices hit different sectors with variable intensity, prompting a large shift in relative prices and a slow but persistent response of core inflation. This was particularly important in the euro area, which has typically experienced persistent inflation in response to energy shocks.

While highlighting the costs and risks associated with different monetary policy choices, the authors suggest that de-anchoring risks are limited and that when an economy with nominal rigidities is hit by an uneven shock, it may be necessary to be patient and tolerate somewhat higher inflation to facilitate the relative price adjustment and the efficient allocation of resources across sectors. The stability of long-term inflation expectations observed in the recent past is a credibility bonus that central banks can exploit to communicate the rationale for taking a bit longer to return inflation to target.

Report authors: Veronica Guerrieri, Michala Marcussen, Lucrezia Reichlin and Silvana Tenreyro

Join Veronica Guerrieri, Lucrezia Reichlin and Martin Sandbu at this online launch hosted by CEPR.