How long will inflation remain high?

Inflation in 2025 will be around the fervently desired level of 2%. Unemployment that will climb to 4,6% this year (still very low, historically) only to fall again in the following years. Economic growth that will be between 1,5 and 2% per year in the coming years. And the American central bank (Fed), which can cut interest rates considerably in 2024 and 25.

That is what the members of the Fed's interest rate committee expect for the coming years. In other words: it is a scenario in which everything goes well and everything goes exactly as you want it to go. There are no setbacks, for example in the form of external shocks. Of course, anything can happen. But how plausible is such a scenario? Well, not exactly. And no, I'm not saying that. So say two researchers from the Fed itself, more precisely from the regional central bank in Cleveland.

Unemployment should more than double
They have looked at historical relationships between various economic variables to determine, for example, by how much unemployment must rise to bring inflation to 2% within two to three years. Their conclusion: the unemployment rate should rise to 7,5%. That is double compared to the current state of affairs in that area (3,5%) plus a little more.

Now, the Fed has been saying for some time that unemployment needs to rise to bring inflation down. But then the bank is talking about a climb towards 5%, not to 7% and more. In fact, that is what the bank wants to prevent and must prevent. The Fed's legal task is to ensure price stability and maximum employment. The latter is the case if unemployment is between 4 and 5%. At an unemployment rate of over 7%, the Fed is failing, whatever yardstick you use.

Luring inflation genie into a bottle takes a long time
That is what the bank wants to prevent. How? By lowering interest rates again as soon as it looks like unemployment is about to get too high. The price for this is that pushing inflation to 2% becomes less likely. In other words: that inflation will remain on the high side for longer. 'Longer' then easily means at least a few years. We know from the past that once the inflationary genie escapes from the bottle, it takes policymakers a long time to lure it back into the bottle. How long? History tells us that when inflation reaches 6% or more, it can easily take a decade or so before it drops back to 2%.

Let it be different this time. But even then, history inexorably indicates that there is a good chance that we will have to learn to live for years to come with inflation rates that are considerably higher than we have been used to on the basis of recent decades.

Edin Mujagic

Edin Mujagić is an economist and manager at Beleggingsfonds Hoofbosch. He focuses on global central banks, and in his blogs he writes mainly about developments in interest rates and inflation. He has also written several books.

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