Let’s talk about… inflation

Of the multitude of macroeconomic variables that exist, inflation arguably ranks among the ones most feared. However, it frequently gets misinterpreted, but not just by investors and consumers. Inflation routinely also befuddles central bank officials over and over. But we can’t just simply ignore it because inflation plays a role even with regard to US presidential elections. So, it’s better to know as much about it as possible. Below we try to answer some frequently asked questions about inflation.

Why is inflation so despised?

Inflation truly is a loathed financial variable. But why actually? After all, as a general rule, inflation decreases the value of debt. Inflation thus should at least delight debtors. Moreover, currencies in theory are really just units of account. If a pizza today costs 20 francs, I need 100 francs to buy five of them. If the same pizza tomorrow costs 30 francs, then I need 150 francs to buy five. But, unfortunately, it isn’t as simple as that because I won’t have 50% more purchasing power tomorrow. Wages tend to rise sluggishly, lagging behind inflation, and that’s the real problem for many consumers. Inflation makes them subjectively feel poorer – and often also renders them objectively poorer in the near term – because it takes a while for paychecks to adjust to the new general price level. Debtors, too, don’t benefit until the moment that they are able make their fixed repayment installments out of a higher nominal income. Robert Shiller described the problem of wage rigidity and its effects back in the 1990s.¹

Two new surveys conducted in the United States by Harvard economist Stefanie Stantcheva² confirm Shiller’s discoveries made at that time. Stantcheva found that (US) consumers’ aversion to inflation stems from the widespread conviction that their wages cannot keep pace with rising prices, that they are left poorer on balance, and that they therefore are forced to adjust their spending behavior (reducing the quality or quantity of the goods they purchase). Stantcheva, however, also uncovered some other interesting findings. She discovered, for example, that when prices rise, people tend to blame the government or businesses for that. Who exactly gets blamed depends on a person’s political mindset. Republicans tend to blame Joe Biden while Democrats are more likely to blame greedy companies. When wages increase, most people do not attribute that to inflation, but instead tend to identify their own on-the-job performance as the reason for the raise. Two-thirds of the survey respondents said they believe that inflation generally indicates a “poor state of the economy.” In reality, though, inflation can in fact be caused precisely by economic growth and low unemployment. According to Stantcheva’s evaluation of the survey results, the majority of the respondents additionally believe that the wages of people with high incomes rise faster during periods of inflation, exacerbating inequality. A fact check reveals that this actually hasn’t happened, at least not during the post-pandemic years. People across all income brackets report that they feel more stressed by rising prices. Eighty-seven percent of the survey respondents said that’s why they sometimes or frequently are angered by inflation. This probably is the reason why US President Joe Biden and his election campaign team are watching inflation statistics like a hawk right now.

Contrary to popular belief | No widening wage inequality

Evolution of income by income bracket

Sources: Autor, Dube & McGrew, Kaiser Partner Privatbank

Why do (most) central banks have a 2% inflation target?

Thirteen out of 16 central banks in the industrialized nations consider 2% the optimal rate of inflation. The history of this widespread inflation target stretches back more than 30 years. However, in the beginning, in contrast to today, it was not a long-term target. When the Reserve Bank of New Zealand issued a (3.5%) target for the first time in 1990, it was intended more as a short-term benchmark after years of excessive inflation. But inflation targeting was soon copied by the Bank of Canada (BoC) in 1991, though not without a good deal of skepticism – at a meeting of the Bank for International Settlements (BIS), the BoC was accused of putting its reputation at stake because it is difficult to abide by such an explicit mandate, the BIS said. The BoC likewise started off with an inflation target of 3.5%, which it then continually lowered to 2% by 1995. In Europe, in turn, the Bank of England in 1992 was the first to issue an inflation target after the UK exited the European Monetary System. Today, a 2% rate of inflation is considered the gold standard, but what exactly makes that number so relevant for monetary policy?

• Prevention of deflation: Deflation brakes economic activity because it prompts consumers to spend less money in expectation of lower prices in the future. In addition, deflation raises the real value of debt, which can lead to higher default rates and financial instability. A moderate 2% inflation target creates a buffer against the risk of deflation.
• Sound growth: (Overly) high inflation necessitates a restrictive monetary policy, which stifles economic growth. Under the highly controversial concept of the Phillips curve, the dual goals of price stability and full employment can best be achieved at a 2% rate of inflation.
• Price stability and stable underlying conditions: (Overly) high inflation erodes purchasing power, devalues savings, and causes uncertainty. Central banks seek price stability and strive to combat the aforementioned adverse effects by aiming for a relatively low inflation rate of 2%. Moreover, studies from the 1990s showed that inflation statistics tend to overstate the actual general price trend. If that’s true, a 2% rate of inflation therefore would be closer to “stable” prices than one would suspect at first glance.
• Expectation formation and credibility: By defining a straightforward inflation target, central banks try to anchor the public’s inflation expectations. If businesses and consumers proceed on the assumption that inflation will stay in the sweet spot at a level of around 2%, they incorporate their expectations into pricing, wage negotiations, and contracts. This leads to more stable economic growth dynamics and ultimately enhances a central bank’s credibility.
• Monetary-policy leeway: An inflation target of 0% would give central banks little room to cut policy rates during phases of weak economic activity. A 2% target, in contrast, enables central banks to stimulate economic activity via lower (or even negative) real interest rates.

As the points above illustrate, the 2% target isn’t an arbitrary figure, but rather is the result of empirical evidence and experience. At a rate of 2%, inflation is neither excessively high enough to harm economic activity nor overly low enough to risk turning into deflation. Last but not least, there is also an international policy consensus on the 2% target, which may very well be in the interest of the central bank community because if everyone is pursuing the same inflation target, central bank officials cannot be so easily accused of acting irresponsibly. Nobel economics laureate Paul Krugman calls that the “great advantage of conventionality.”

A matter of the time horizon | Central banks have reached the 2% target over the long run

Core inflation rates

Sources: Autor, Dube & McGrew, Kaiser Partner Privatbank

Should central banks have reacted more swiftly to the surge in inflation?

Inflation in Switzerland has long since returned to within the Swiss National Bank’s comfort zone, and inflation in the Eurozone has already pulled back enough in recent months so that a 2 now precedes the decimal point again. The European Central Bank probably would gladly like to take credit for this “success” in taming inflation, almost forgetting that it wasn’t all that long ago that the ECB came under sharp criticism for allegedly having raised interest rates far too late. But would the ECB really have been able to prevent inflation from surging to double-digit territory by hiking interest rates sooner and more vigorously? A real-life experiment tracking the evolution of inflation in the Czech Republic and Slovakia over the last three years provides an answer to that question.

Those two small open national economies are highly integrated into European supply chains. They were part of Czechoslovakia until that country’s breakup in 1992. The big difference between them today is that Slovakia has been a member of the Eurozone since 2009 and has thus “outsourced” its monetary policy to the ECB. The Czech Republic, in contrast, continues to have its own central bank (the Czech National Bank (CNB)), its own currency (the Czech koruna), and its own monetary policy. When inflation spiked as a result of the pandemic shock, the CNB reacted quickly and implemented an initial interest-rate hike in June 2021. Over the next 12 months, it raised its policy rate by a total of 675 basis points. The benchmark lending rate in the Czech Republic thus stood at 7% before the ECB even began to initiate its rate-hiking cycle. The ECB didn’t undertake its first rate hike until July 2022 and subsequently raised its policy rate by a total of just 450 basis points to 4%. Despite those very different monetary-policy approaches, both countries have exhibited astoundingly similar inflation trajectories.

Different monetary policies… | …but similar inflation trajectories

Policy rates and inflation rates

Sources: Autor, Dube & McGrew, Kaiser Partner Privatbank

The experiment confirms that inflation in both countries was caused primarily by external supply shocks and was not driven by domestic demand. Conversely, the subsequent disinflation in both countries is mainly attributable to the recovery from the supply-chain and raw-material price shock. Central banks could not influence those external factors through their interest-rate policies. Even though the European Central Bank evidently was way behind the curve in the current interest-rate cycle, an earlier reaction arguably wouldn’t have altered the inflation trajectory at all. Against this backdrop, the partially gruff criticism of central-bank officials in recent years was perhaps a bit overblown in some isolated instances.

Why is inflation in Switzerland so low?

Switzerland in recent years has provided impressive proof validating its reputation as an island of monetary stability and has reaped many an envious stare from abroad because of that. Whereas inflation climbed to a peak of 9.1% in the USA and even exceeded 10% for a time in the Eurozone, it topped out at just 3.5% in Switzerland. Inflation in Switzerland has been back below 2% for already a year now. Yet even the brief and moderate rise in inflation in international comparison caused some bellyaching here and there among the Swiss. Many of them implicitly regard low inflation as almost a law of nature. There are multiple reasons behind the Swiss inflation phenomenon:

• Strong franc: Recent decades have seen the Swiss franc appreciate continually against all of the other major currencies. It is considered one of the few safe havens on the financial market. Switzerland’s steadfast political and economic stability is valued by investors, particularly in turbulent times. The strength of the franc mitigates inflation from imported goods. The Swiss National Bank actively leverages this effect whenever necessary. Between spring 2022 and autumn 2023, the SNB sold CHF 140 billion worth of foreign-currency holdings. This contributed to increasing the external value of the franc and absorbed part of the upward price pressure from abroad.
• Credible central bank: The SNB is held in high esteem on the international capital market, largely as a result of its excellent track record in combating inflation. Its price-stability target range of 0%–2% is more stringently defined than the ones pursued by other central banks. While the US Federal Reserve strives for full employment in addition to keeping inflation low and whereas the ECB would like to go one step further by also incorporating sustainability aspects in its monetary policy, the SNB focuses exclusively on price stability. The SNB places a higher priority on keeping inflation under control than other central banks do.
• Sound fiscal policy: A certain culture of stability also prevails in Switzerland’s fiscal policy. The country’s national debt brake ensures that Switzerland’s public debt load, at 39% of GDP, is much lower than the public debt burden in Italy (144%), France (112%), and Germany (67%), for example. The SNB therefore is not under pressure to help out the state by keeping interest rates low or by buying government bonds. There is a broad political consensus in Switzerland on the necessity of maintaining an independent central bank. That reinforces trust in the Swiss franc.
• General wage restraint: The risk of a wage-price spiral tends to be lower in Switzerland than elsewhere. General wage restraint, wage-setting practices that are mostly decentralized in individual companies, a culture of consensus between employers and employees, and constant wage pressure due to high immigration normally ensure that no appreciable second-round effects arise in Switzerland, unlike in other countries.
• Strong competitive pressure: Since Switzerland is surrounded by countries with substantially lower price levels, Swiss companies constantly face fierce competition from abroad. The strong franc compels innovation, high productivity, and cost efficiency. The fierce intensity of competition makes a noteworthy contribution to keeping inflation in Switzerland low.
• Customs protections for agricultural goods: Due to its protectionist agricultural policy, Switzerland imports little food. The prices of agricultural goods that nonetheless do get imported are often adjusted to the domestic price level by applying customs duties. Price fluctuations on global food markets therefore have little effect on food shelf prices in Switzerland.
• Inertial state prices: One-quarter of all consumer prices (e.g. electricity prices) in Switzerland are administered by the state. Although this does not prevent inflation in general, it does smooth out price movements.
• Energy mix and energy efficiency: Switzerland covers a large part of its electricity needs with non-fossil energy sources such as hydropower (62%) and atomic power (29%). Fluctuations on the international energy market (in the natural gas space, for example) therefore do not cause an immediate price shock in Switzerland. Moreover, Switzerland exhibits low energy intensity because it has fewer energy-intensive industries than other countries do and produces with comparatively greater energy efficiency in those sectors.

1) Shiller, R. J. (1997): Why do people dislike inflation?

2) Stantcheva, S. (2024): Why do we dislike inflation?