Untangling Persistent Inflation: Understanding the Factors at Work

While recent inflation numbers have been encouraging, persistent inflationary pressures remain a topic of concern and policy deliberation. This article delves into some candidate drivers of inflation persistence and their implications for monetary policy. In particular, we explore factors contributing to the persistence of inflation, such as intrinsic persistence, complementarities, indexation, unanchoring of expectations, fiscal policy and other persistent inflationary shocks.

Inflation rose rapidly in the fall of 2021 as pandemic restrictions were lifted and individuals drew on excess savings and successive rounds of fiscal transfers. Monetary policy then tightened rapidly in 2022, but inflation has only receded gradually.

While the inflation surge seems to be waning, it remains a source of policy concern, as it is still above the Federal Open Market Committee's goal of 2 percent over the long term.

Mapping the way forward requires understanding the source of inflation persistence. Inflation persistence may be understood as intrinsic or extrinsic. Intrinsic persistence emerges from the internal dynamics of price-setting and wage-setting decisions. It implies that one should expect inflation to remain high for a long time following a large but short-lived increase in inflationary pressures. In contrast, extrinsic persistence emerges from the fact that inflation reflects other persistent processes that drive production costs and price-setting incentives.

In this article, I explore some of the factors that can contribute to extrinsic or intrinsic inflation persistence and assess their relevance in the current context as well as their policy implications.

Intrinsic Inflation Persistence

Intrinsic inflation persistence can emerge from the fact that price changes are staggered across firms or products, as not all firms change their prices continuously. Rather, at any given point, some firms opt to change their prices, while others keep them fixed and wait to change them later. Therefore, inflation remains high because of the time it takes for all firms to react more broadly to a change in monetary policy or the economic environment. In particular, inflation will surge for as long as it takes for all firms to adjust the prices of all their products.

This persistence channel is particularly potent if firms change their prices at regular intervals. In practice, some sellers (such as gas stations) change their prices almost daily, whereas others (such as some services) may keep their prices in place for several years. Such heterogeneity may lead to a quick overshoot by flexible price firms followed by declining inflation as those firms correct back, whereas firms with very sticky prices only follow suit much later with smaller increases.

On net, the evidence is that at any point in time, there is an even mix of firms newly reacting to changes in the economic environment and those still in the process of adjusting to older news,¹ leading to relatively little intrinsic persistence.² At most, this source of persistence could explain inflation up to a year, which is about the time that it takes most firms to change their prices.

"Catching Up" Inflation With Complementarities

In the intrinsic inflation process described above, each firm reacts to the macroeconomic environment but not to each other. In practice, firms observe and factor in other prices when setting their own. Indeed, firms might be more likely to increase prices when their suppliers or competitors have higher prices. In technical terms, higher prices will likely be strategically complementary across firms.

When such complementarities come into play, inflationary shocks gain additional momentum. Strategic complementarities among firms can amplify the adjustment process, leading to a chain reaction where firms adjust their prices based on the actions of their competitors or on the price of inputs. As firms increase their prices, their competitors and customers then adjust their prices, and so on. This phenomenon can create a cycle of price adjustments, potentially driving inflation forward.

Wage-price spirals exhibit similar dynamics:³ As firms increase their prices, workers demand higher wages, and as they demand higher wages, firms increase their prices. As price-setters and wage-setters take turns making their adjustments, they may not fully adjust to where they think their prices and/or wages will ultimately end up at each step along the way. Rather, price-setting firms may wait for wages to increase before undertaking new rounds of price adjustment, and workers and firms negotiating wages may similarly wait for prices to be set. Inflation then remains high for as long as this adjustment process takes place.

Finally, complementarities may lead to inflationary dynamics dominated by firms with the stickiest prices, which take the longest to adjust to changing economic conditions. Given the pervasive nature of input-output linkages in the economy, complementarities are likely to play a significant role in inflation persistence.

Indexation

One further source of intrinsic inflation persistence is indexation. Indexation refers to automatically adjusting prices or wages in response to incoming inflation data. If firms or workers perceive inflation to be persistently high, they may adopt indexation in contracts to keep up with rising prices without recalculating increases at each turn. Thus, high inflation numbers are followed by high price increases, leading to persistence.

Explicit indexation was common in less developed economies such as Brazil or Chile during periods of high inflation. It added difficulty to stabilization plans, requiring creative solutions to convince firms to change their behavior. However, such explicit indexation was adopted in countries with inflation at levels higher than what is observed in the U.S. Hence, it is unlikely to become an issue in the U.S. economy.

Nevertheless, a more subtle version of indexation may occur as a passive rule of thumb adopted by firms when adjusting prices infrequently, allowing them to reflect perceived inflation trends automatically. This may be particularly salient in regulated sectors such as shelters, where landlords may need to use inflation data to justify rent increases. Policy responses to such implicit indexation should focus on effective communication and, if necessary, cautionary measures to avoid the potential pitfalls of this mechanism.

Unanchoring

Inflation can also become more persistent when long-run inflation expectations become unanchored. When a central bank has credibility, price setters understand that it will fight inflation increases so that inflation eventually settles at some widely understood target level over long periods.

However, if inflation continues to exhibit strong swings, some agents may ask themselves what the central bank's true long-term target is. Perhaps, they may reason, the central bank does not intend to bring inflation back to the previously accepted target (for example, 2 percent) but will instead be satisfied if it settles at an additional 1-2 percentage points higher. Such a scenario may lead firms to set higher prices in anticipation of permanently higher inflation.

Regarding inflation persistence, such unanchoring may lead to private agents trying to infer the central bank's objective from incoming inflation data. Thus, a year of inflation above, say, 5 percent may lead firms to imagine high inflation is the new normal and behave accordingly.⁴

While worrisome, available data on longer-run inflation expectations do not suggest that such unanchoring is taking place at a large scale.⁵ Yet, the risk of unanchoring remains one that monetary authorities ought to remain focused on. Communication is crucial in addressing unanchoring concerns. However, if the issue stems also from a credibility problem, actions may speak louder than words, and achieving lower inflation expectations may require a sustained period of consistently low inflation and potentially higher unemployment rates.

Extrinsic Persistence

Fiscal Policy

Fiscal policy can exert a persistent inflationary impact by altering balance sheets within the economy. Policies involving transfers or large increases in government debt (not backed by expectations of future taxes in coming years) can increase aggregate demand and, consequently, inflation. The effects of fiscal policy on inflation may persist until households spend their windfall or inflation erodes the value of government debt, bringing it back to more sustainable levels.⁶

In the U.S., recent increases in debt-to-GDP ratios may suggest that fiscal policy has contributed to inflationary pressures. Fiscal policy measures should therefore be carefully considered to mitigate potential inflationary effects.

Labor Market Persistence

To the extent that inflationary pressures arise when the labor market is tight, inflation persistence may be a function of labor market persistence. Employment typically moves more slowly than output and rises with a lag. Inflation persistence may then simply be a consequence of intrinsic persistence in employment.

Employment has grown persistently since 2021 (albeit at declining rates), and the unemployment rate has stayed low. Under this view, inflation will remain elevated for as long as the labor market remains tight.

Other Persistent Inflationary Shocks

Persistent inflation can also arise from persistent supply chain disruptions and commodity price fluctuations. While supply chain issues have been a significant concern in recent years, their impact on inflation is expected to diminish over time. Consequently, if this were the main cause of inflation persistence, policymakers are best off exercising patience and allow these shocks to work themselves out naturally.

Summary and Policy Implications

Persistent inflation may stem from various factors, including complementarities, fiscal policy and other inflationary shocks. Many of the sources of persistence — whether intrinsic or extrinsic — work themselves out over time, suggesting that central banks should remain patient and adopt effective communication strategies to address persistent inflation.

The recent decline in inflation numbers suggest that many sources of intrinsic sources of inflation persistence may have had enough to time to play themselves out. Furthermore, impulses coming from fiscal expansion, supply chains and commodity prices appear to have run much of their course. So long as inflation expectations remain anchored, one may have reasons to be optimistic that inflation will converge on the Federal Reserve's target in the coming year.

However, if indexation or unanchoring appear to contribute to inflation persistence, a commitment to low inflation must be signaled, potentially requiring higher unemployment rates in the short term to reset inflation expectations.

Additionally, careful fiscal policy management is crucial to avoid exacerbating inflationary pressures. While waiting for these factors to subside naturally, policymakers should remain vigilant and responsive to ensure long-term price stability.

Felipe Schwartzman is a senior economist in the Research Department of the Federal Reserve Bank of Richmond.

To cite this Economic Brief, please use the following format: Schwartzman, Felipe. (September 2023) "Untangling Persistent Inflation: Understanding the Factors at Work." Federal Reserve Bank of Richmond Economic Brief, No. 23-31.

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Views expressed in this article are those of the author and not necessarily those of the Federal Reserve Bank of Richmond or the Federal Reserve System.