Who has won the inflation debate - Team Transitory or Team Permanent?

When inflation started to spike in 2021, many policymakers and economists dismissed the problem as transient. According to “Team Transitory”, central banks did not need to slow economic activity by raising interest rates aggressively because price pressures would soon subside as Covid-19 disruptions dissipated. Others disagreed. Excessive government fiscal stimulus and central bank bond-buying programmes risked permanently raising inflation, they said. According to “Team Permanent”, central banks needed to raise rates sharply.

The rift between those who said inflation was transient and those who thought it permanent partly reflected differences over what caused prices to rise in the first place. One explanation stressed that inflation rose at the same time in most countries because they were subjected—to varying degrees—to a similar sequence of shocks: The Covid-19 pandemic, mobility restrictions, and the associated set of economic policy measures, especially the extent of fiscal and monetary support. More fiscal and monetary support, tighter labour markets or less-well anchored inflation expectations could translate into persistently higher inflation, which, as “Team Permanent” argued, would necessitate restrictive monetary policy to curb demand.

Another explanation stressed that inflation rose everywhere at the same time because global causes were at play. The surge in energy and food prices, rendered especially acute by Russia’s invasion of Ukraine, triggered an international energy crisis akin to that of the oil price shocks of the 1970s. Geopolitics was the cause of both series of events. And it’s true that global energy prices and headline inflation moved upwards together (Chart 1). The striking fact is that even as food and energy prices rose sharply, long-term inflation expectations held steady.

A new study covering 21 advanced and emerging economies sheds light on these inflation debates. Overall, we find that shocks — such as rise in food and energy prices, or increase in shipping costs, and supply-chain disruptions — and the “pass-through” of these shocks into underlying inflation accounted for the bulk of the rise and fall of inflation. The pass-through from these industry price shocks to underlying inflation occurred through the effects of higher inflation on wages and other production costs. On the other hand, broader measures of macroeconomic slack and changes in longer-term inflation expectations generally contributed little (Chart 2).

The United States is a significant exception. Despite considerably easing since early 2023, the contribution of broad macroeconomic tightness to inflation was greater than in other economies. The fall from the peak in underlying inflation in February 2023 reflected approximately equal contributions from the cooling of the broader economy and the fading of pass-through from earlier shocks. Since March 2024, however, US labour market conditions have further moderated, and this should help inflation return to the Fed’s target.

India is another exception. The rise to peak for India was reported at the lowest in our sample. While the macroeconomic conditions contributed positively to the rise in inflation from December 2020 to its peak, this contribution reflected recovery from a below-trend path of output in 2020 rather than an overheated economy.

So, who can rightfully claim victory, Team Transitory or Team Permanent? Perhaps it is a draw — both were partly correct. It is hard to disentangle a classic chicken and egg issue. The vigilance of Team Permanent coincided with the most synchronised global tightening of monetary policy during this episode. Monetary policy had a critical role to play in defeating inflation. Throughout this period, long-term inflation expectations remained well anchored (Chart 1). Central banks retained their credibility, and this helped to avoid wage-price spirals. Global tightening of monetary policy may also have helped bring down global demand and hence energy prices. Had global monetary policy not played a significant role, the inflation outcomes could have been different.

At the same time, energy shocks and their pass-through accounted for the bulk of the rise and fall in inflation, without the need for a deep slowdown in activity. Ultimately, inflation receded as swiftly as it had emerged, which led economists such as Joseph Stiglitz to assert, “We in Team Transitory can rightly claim victory”.

The writer is professor of economics at Ashoka University, and director and head of Ashoka Isaac Center for Public Policy. The views are personal. This article draws on “Understanding the International Rise and Fall of Inflation Since 2020,” a paper published in the Journal of Monetary Economics