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It will take longer to contain inflation than most people think, but containing it does not necessarily mean significantly higher unemployment, and premature easing of monetary policy could be dangerous.

These are the key conclusions of a new IMF working paper released on Friday that examined the lessons of over 100 different inflation shocks in 56 countries since the 1970s.

Given its obvious timeliness, we’re surprised the paper hasn’t already made a bigger splash, but Alphaville suspects it will provide ammunition for many central bank hawks at an interesting time for monetary policy.

Here is the commentary from economists Anil Ari, Carlos Mulas-Granados, Victor Mylonas, Lev Ratnovski and Wei Zhao:

We document that in only 60 percent of cases was inflation reduced (or “resolved”) within five years, and that even in these “successful” cases, it took, on average, more than three years to resolve inflation. For episodes triggered by terms of trade shocks during the oil crises of 1973 to 1979, success rates were lower and resolution times were longer. Most of the unresolved episodes involved “premature celebrations” in which inflation initially declined, then stagnated at elevated levels or accelerated again. Countries where inflation was resolved had tighter monetary policies that were maintained more consistently over time, lower nominal wage growth, and less currency devaluation compared to unresolved cases. Successful disinflations were associated with short-term output losses, but not with major output, employment, or real wage losses over a five-year horizon, perhaps indicating the value of policy credibility and macroeconomic stability.

These are the abridged conclusions of seven “stylized facts” that the IMF economists drew from their data work. You can read the full paper here, but here are our quick summaries of it.

Fact 1

Inflation continues, particularly after shocks to the terms of trade

It is easy to believe that inflation shocks caused by a sudden explosion in energy or food prices will subside once the underlying cause (embargoes, wars, bad weather, etc.) disappears.

However, in twelve of the 111 inflation episodes studied by the IMF, inflation only returned to pre-shock levels after a year, and in most of these cases this only occurred due to a massive economic shock such as the 2007/2008 financial crisis or the 1997 Asian financial crisis -98. In other words, they were not examples of “impeccable disinflation.”

In 47 episodes examined, inflation had still not returned to normal 5 years, Furthermore, the average time it took for inflation to return to pre-shock levels was three years.

Fact 2

Most unresolved inflation episodes were “premature celebrations”

This argument seems particularly relevant today. In almost all cases of persistent inflation shocks, inflation fell “significantly” in the first three years, then stagnated at a high level or accelerated again.

The IMF believes this is likely due to premature easing of monetary policy or governments easing monetary policy too early.

Fact 3

Countries that managed to beat inflation had tighter monetary policies

One of the IMF’s key findings was that successful resolution of inflation shocks tended to be achieved when central banks raised interest rates to combat them, regardless of the cause:

The difference in monetary tightening between countries that have solved inflation and those that have not is statistically significant, quantitatively large, and consistent across measures. On average, countries that had resolved inflation increased their effective real short-term interest rate by about 1 percentage point compared to the situation before the shock, while the real interest rate in countries that had not resolved inflation was on average 4.5 percentage points lower was like before the shock -shock.

Fact 4

Countries that have solved inflation STAY AT IT

The implication of facts 2 and 3 is that successful inflation battles tended to occur when central banks both raised interest rates and kept them high for longer (and governments also pursued restrictive fiscal policies). D’oh.

Fact 5

Countries that solved inflation suffered limited currency devaluation

Another [annoyed grunt] Point, to be honest. Countries that successfully combated inflation (through longer-term higher interest rates) were able to either maintain their currency pegs or limit the devaluation of their currency.

Fact 6

Countries where inflation was resolved experienced lower nominal wage growth

As might be expected, countries with tighter monetary and fiscal policies experienced more moderate wage growth, while countries that did not experience accelerated wage growth – although mostly only in nominal terms.

In real terms, countries that managed to beat inflation experienced only slightly smaller losses in earnings growth over time.

The IMF warns that the difference is too small to be statistically significant and that it could be distorted by a smaller sample size (wage growth data is not good for the entire sample). But it’s interesting that the difference is quite modest.

Fact 7

Countries that outperformed inflation experienced neither lower growth nor higher unemployment

This is the most interesting result of the paper. It is assumed that aggressive monetary and/or fiscal tightening would cause significant economic damage. But instead:

Over the 5-year horizon, we find no statistically significant difference in growth outcomes between countries where inflation was resolved and those where it was not. While inflation shocks reduce growth and increase unemployment whether they are resolved or not, the mean and median output declines in unresolved episodes are slightly larger in the medium term.

So what does that mean? How relevant is this historical exercise to today’s problems? It’s difficult to say.

It is significant that well over half of the episodes studied by the IMF were caused by the oil crisis of 1973 to 1979. As Isabella Weber et al. have written, energy is, along with food, one of the most “systemic” components of inflation.

However, the recent surge in inflation was at least partly triggered first by supply chain bottlenecks caused by the pandemic, then fueled by a demand shock as people went on a post-pandemic shopping spree, and most recently by Russia’s invasion of Ukraine.

Therefore, history may be a poor guide to today’s situation. But some central bank officials will definitely interpret this as evidence of how they should increase monetary policy and stay tighter for longer.

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