In response to a combination of demand and supply shocks following the reopening of economies after the Covid-19 pandemic eased, inflation started to rise around the summer of 2021. Since then, inflation rates have climbed well above central banks’ targets almost everywhere. Higher energy and food costs due to the war in Ukraine added further upward pressures.
Within this landscape, long-term inflation expectations have generally remained anchored, suggesting that the public at large trusts central banks to bring inflation back down to target rates. In this respect, an important question concerns the speed with which central banks should disinflate the economy. The ‘cold turkey’ approach to disinflation emphasises the benefits of acting fast to restore anchored inflation expectations and safeguarding central bank credibility (Sargent 1983, Ball 1994). The gradual approach to disinflation assumes that output costs would be lower if prices and wages had time to adjust to monetary tightening (Taylor 1983). Subsequent literature has studied the balance between these polar views (e.g. Ascari and Ropele 2013, Gibbs and Kulish 2017, and the references therein).
We contribute to this debate by collecting views from a global survey of leading researchers in economics and finance on issues pertaining to monetary policy, including the preferred speed of disinflation. Partly as a follow-up to our earlier work (Ambrocio et al. 2022a, 2022b), we ran the survey in December 2022 and received responses from about 400 participants worldwide. In the global sample of respondents who come from inflation targeting countries, the median respondent would like to see central banks closing a little over 70% of the gap between current inflation (in December 2022) and the inflation target within a one-year horizon. The median euro area respondent prefers a somewhat slower speed of disinflation than their US counterpart. Regarding the risks to inflation and monetary policy, very few respondents flagged risks in the banking sector, and none specifically mentioned the interest rate risk arising from a maturity mismatch of bank assets and liabilities.
The path to the target
We can think of the speed and path of disinflation that a central bank wishes to engineer as a plan that translates into implicit interim targets on the way back to the actual inflation target.
Building on this idea, we asked experts the following question:
Given that the inflation rate over the past year was … (%), what rate of inflation should the central bank seek to achieve by the end of 2023?
In the two leading currency areas – the euro area and the US – where the central bank has a 2% inflation target, the median answers were 4.5% and 3.5%, respectively. Hence, in neither region does the median respondent suggest that the central bank should complete the disinflation phase by the end of 2023.
When aggregating the responses, we need to consider the different levels of inflation that prevailed in different countries and currency areas at the time of the survey, and that central banks may have different inflation targets. For instance, by the end of December 2022, the reported inflation rate was about 11% in the euro area and about 8% in the US on an annualised basis. Consequently, the gap between current inflation and the central bank’s inflation target was much wider (about nine percentage points) in the euro area than in the US (about six percentage points). To make individual responses comparable, we calculate how much of this gap a respondent would like to see closed by the end of 2023, which is a measure implied by their preferred interim target choice.
Table 1 The preferred speed of disinflation: how much of the gap between current inflation and the inflation target should be closed by the end of 2023?
Note: The sample consists of responses from participants who prefer the central bank to have an explicit inflation target, asked about in one of the survey questions.
Table 1 displays the results of this exercise. The median preferred speed of disinflation in terms of closing the ‘inflation gap’ in one year’s time is 72% in the global sample, 67% in the euro area, and 75% in the US.
The difference between the euro area and the US suggests that the preferred speed of disinflation need not be the same everywhere. One reason is that different shocks may drive inflation in different regions. A common narrative of the current outlook is that in the US the recent bout of inflation is more demand-driven, while in the euro area supply shocks have played a bigger role (e.g. Furman 2022, Lagarde 2022). Hence, the ECB might have found itself in a less favourable position than the Fed, given the root causes of inflation and their effect on economic activity. These considerations might prompt more cautious views among respondents regarding the speed of disinflation in the euro area.
Moreover, our survey also revealed that the euro area respondents are more concerned than their US peers about monetary policy decisions being currently constrained by fiscal sustainability considerations, which might also make them more cautious about the appropriate speed of disinflation.
Respondents are quite confident about central banks’ ability to reach their inflation targets by the end of 2025 (over the three-year horizon as of December 2022, when we conducted the survey). Table 2 shows that in the global sample, 73% of respondents believe this outcome is likely or very likely. However, the euro area respondents are somewhat less optimistic, especially when compared to their US peers (68% versus 77%). This finding is consistent with the previous result that the euro area respondents prefer a somewhat slower speed of disinflation.
Table 2 Likelihood of hitting the target over the next three years
Risks on the way
Central banks must navigate various risks while conducting monetary policy to achieve their goals. In our survey, we also asked participants about such risks and invited textual answers. The idea is to encourage survey participants to write about the most significant risks in their own words instead of restricting their answers by offering multiple-choice, pre-specified options. Not only can textual answers provide information about the order of importance of known risks, they also point out lesser-known risks that policymakers should consider more carefully.
Specifically, we asked:
What are the biggest risks to inflation and monetary policy currently and over the next year faced by the central bank?
The most frequent topic featuring in the survey responses focuses on the risk of inflation expectations becoming un-anchored and wages starting to increase in response to elevated inflation.
This concern appears to be related to wage-price spirals as an important element of inflation dynamics, as analysed by Blanchard (1986) and, more recently, by Lorenzoni and Werning (2023).
Other relatively frequently mentioned topics focus on the difficult balancing act between raising interest rates too high or too fast to induce a recession versus not tightening sufficiently and aggressively enough to control inflation; and on supply-side and geopolitical factors as root causes of the current and short-term risks to inflation and monetary policy.
A follow-up question asked how well the central bank has managed the biggest risks to inflation and monetary policy over the past year (2022). Central banks have been criticised for being ‘behind the curve’ in responding to the inflation shock. For example, Reis (2022) analysed a number of possible reasons for why the response of monetary policy may have been slow. We find that most participants (about 60% in the whole sample) are relatively satisfied with the performance of central banks, although some regional differences exist. US respondents are somewhat more satisfied, with 65% judging the Fed’s performance as somewhat/very appropriate. The corresponding euro area figure concerning the ECB’s performance is 58%.
Did experts ‘warn’ about interest rate risk in bank balance sheets?
Between December 2022, when we ran the survey, and the time of writing, the monetary tightening cycle has exposed the banking sector to potential balance sheet interest rate risk (Jiang et al. 2023). Against this backdrop, an obvious question is whether the survey participants anticipated problems in the banking sector. Interestingly, we find no responses that specifically mention maturity mismatches in assets and liabilities that could expose banks to the effects of higher interest rates. Only a few respondents mention a financial crisis causing problems in banks. One respondent alludes to the risk of extensive corporate defaults. Responses mentioning financial stability are few, and refer mostly to sovereign debt issues. In sum, the turmoil in the banking sector that surfaced in March 2023 was not considered an important risk by our survey respondents in December 2022.
Conclusions
Participants in a global survey of leading researchers in economics and finance that we ran in December 2022 preferred central banks to close a significant part (about 70%) of the gap between prevailing inflation and the inflation target over a one-year horizon. A significant majority believes that those targets will likely, or very likely, be met by the end of 2025. The balancing act between avoiding inflation expectations becoming unanchored and generating a recession is viewed as one of the biggest imminent risks.
Authors’ note: We thank Davide Debortoli, Juha Kilponen, Jarmo Kontulainen, Nigel McClung, Mika Pösö, Tuomas Välimäki, Matti Virén and other colleagues at the Bank of Finland for valuable comments and discussions. We are constantly indebted to Jonna Elonen-Kulmala for implementing the survey and Minna Nyman for research assistance.
References
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