What does 'transitory' inflation really mean?
Media outlets and central bankers alike stated that 2022 was the year of ‘brutal inflation,’ yet, all of them have failed to properly define what they actually mean by the term ‘transitory.’ What started as a term used by central banks such as the Fed to calm inflationary fears has been ingrained into the economic lingo of many experts who describe short-lasting inflationary episodes, but how short-lasting is the inflation exactly?
This is the question that needs answering, for two reasons. First, a lack of precise definition for transitory inflation means that analysts and policymakers can coin the term whenever they wish to provide a manipulated sentiment to readers. Second, if we can pinpoint a specific timeframe for when inflation is transitory, (or when it isn’t) policymakers can do their jobs much more effectively by setting targets with higher degrees of precision. Short-run vs Long-run:
The first distinction we should make when engaging in the transitory or ‘permanent’ inflation debate is whether or not inflation is a short-run or long-run phenomenon. In economics, the short run is a state of time where at least one-factor input is fixed. (broadly speaking) An example of this is a coffee shop being unable to purchase extra capital such as kettles to raise output. As such, in the short run, price increases are much more likely to manifest as the coffee shop would struggle to raise output levels to meet demand increases, thus raising prices.
Extrapolating this principle into the wider economy, we find that inflation which occurs during the short run can be classed as being transitory should it be rectified in the long run. (which is where our coffee shop can buy more capital equipment to raise output) However, such a perspective means that all inflation will be transitory eventually. This is because the price mechanism dictates that producers are signalled and incentivised to meet higher demand because of the increased potential for profit. This makes this perspective not very helpful as it is only functional theoretically with short-run and long-run phenomena being difficult to precisely measure. Consequently, we must look towards a different method of determining the nature of transitory inflation. Pairing Inflation With Monetary Transmission Lags: Monetary policy and the nature of money within an economy is a commonly misunderstood topic area in economics as students are quick to jump to certain conclusions. Some groups may place an overemphasis on money growth whereas others may do the same for the role of interest rates. Nevertheless, one pretty certain principle is the time lag of over a year associated with changes to monetary policy. As such, I suggest that we pair this delay with the natural rate of interest which policymakers aim to achieve as this maximises output (and employment) whilst keeping inflation low. The conclusions from this approach are that if the natural rate of interest is reached and the inflation rate is still above the target after the time lag, then, policymakers can reason that the inflation we are experiencing is not transitory. This means that central bankers who choose to continue raising interest rates even if the supposed natural rate is achieved, then, they will be fighting an uphill battle against inflation which will yield costs to the wider economy through a reduction in output.
Another way to see this is that transitory inflation is inflation that can be solved through monetary policy as it is likely to be attributed towards ‘money’ related factors such as demand and the supply of broad money in the economy, both of which are influenced by changes in monetary policy. Conversely, this creates the unexpected conclusion that more permanent spells of inflation are out of the control of the central bank as they are more likely to be a cause of external shocks to the economy.
Although a short blog post is not enough fully explore this proposal, there is merit in pairing the concept of transitory inflation towards other economic changes and factors such as lag times and the natural rate of interest. Doing so will ultimately make central bank intervention more organised and less costly during times of extended crisis.