The contribution of monetary policy to disinflation

What it says

BIS economists assess what monetary policy did, and did not do, in the 2021 to 2023 inflation episode. They argue most of the surge came from sectoral shocks, chiefly energy, the switch of spending from services to goods and back, and a stronger dollar, which rate rises can barely touch. Some disinflation was therefore coming anyway. The question is whether it would have stuck. Using a medium-scale model of the US economy, they show that a far more aggressive rule would have trimmed inflation only slightly at a large cost in output, but that no tightening at all would have let inflation climb further and fail to return to target, with demand overheating and a bigger recession later. A second model, in which people learn about the central bank from outcomes, shows how slow responses can loosen expectations. The core lesson is that credibility is earned by acting.

What to take from it

1. 1

   Since the mid-1980s, typical inflation outbreaks in advanced economies added about 4 percentage points; in this episode OECD inflation rose almost twice as much.

2. 2

   In the 1970s, the median surge was about 8 percentage points, while the median subsequent disinflation was only half as large.

3. 3

   Short-term inflation expectations rose from mid-2021, then plateaued and fell once tightening accelerated in mid-2022.

4. 4

   The estimated response of inflation to real activity is very small, so cutting inflation by 1 or 2 points through demand alone would require a deep recession.

5. 5

   Had central banks not raised policy rates, the authors' counterfactuals show real interest rates falling sharply, stimulating demand and keeping inflation high.

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