Lessons of Post-COVID Inflation: How Effective Was Inflation Targeting?
The global post-COVID inflation hike in 2021–2023 posed a significant challenge for central banks around the world. For the first time in several decades, since 1970s–1980s, monetary regulators faced a sharp rise in global inflation, which was primarily caused by a series of global supply shocks, from supply chain disruptions to energy price spikes.
Responding (link in Russian) to the uncontrollable increase in inflation over the last quarter of the 20th century, central banks started to adopt the IT regime from the 1990s onwards. Over 35 years, this practice has gained widespread recognition as it has allowed countries (including those suffering from chronically high inflation) to achieve and maintain sustainably low inflation and reduce its volatility.
In a recently published working paper, IMF economists Patrick A. Imam and Tigran Poghosyan presented a statistical analysis comparing how efficiently IT countries managed the post-pandemic inflation surge as compared to non-IT countries. Researchers reviewed the data from 70 countries over 2019–2024, covering the pre-COVID period, the 2022 inflation peak, and its subsequent decline.
The authors describe their findings as ‘mixed’: in this inflation episode, the efforts of IT central banks yielded nearly the same results as those of non-IT regulators. Both country groups experienced inflation growth of a broadly similar magnitude; all central banks tightened their monetary policies (although the tightening was more considerable in IT countries); long-term inflation expectations remained generally stable in all economies; and the disinflation process that began in 2023 was accompanied by a similar slowdown in GDP growth across all countries. In other words, the analysis revealed virtually no differences in terms of the economic dynamics between IT and non-IT countries during this ‘stress test’ of price stability.
Does this mean that IT is ineffective or less effective than its alternatives? Not at all. Quite the opposite, in fact. The 2021–2023 experience shows that the fundamental factor is not only, or even primarily, the de jure adoption of an IT framework, but rather the ability of central banks to de facto adhere to the principles underlying IT.
- First, non-IT countries responded in the same way IT countries did.
Whether a country is an inflation targeter or not is ultimately determined by its response to an inflation rise, that is whether it does or does not tighten its monetary policy, rather than by the formal adoption of an IT framework. The authors demonstrate that in the period of prolonged supply shocks, both IT and non-IT countries tightened monetary policy in response to rising inflation.
More aggressive monetary policy tightening in IT countries could in part be attributed to the fact that monetary policy in non-IT countries had on average already been tighter in the pre-pandemic period (2019–2021), according to the study data. Over this period, rates in non-IT countries were on average higher than those in IT countries by approximately the same margin (0.5–3 pp) as they were lower in 2022–2024.
Therefore, it could only be argued that ‘IT is inefficient’ if non-IT countries did not respond to accelerating inflation at all, or used entirely different tools to counter it (e.g. by implementing rapid fiscal consolidation instead of raising policy rates or limiting lending growth) and achieved similar outcomes to those of IT countries. However, they took the same measures as IT countries, i.e. raised policy rates considerably, achieving very similar (but by no means better) results to those of IT countries.
- Second, many countries that were formally classified as non-IT in fact aim to achieve price stability.
The group of countries that have not officially adopted an IT framework includes those where central banks are explicitly mandated to ensure price stability.
Specifically, in 22 (60%) out of the 37 non-IT countries, central bank websites state price stability as an official monetary policy objective, e.g. in the US and Switzerland. That is, these countries are de facto inflation targeters, even if they do not set a quantitative target. The People’s Bank of China states maintaining a stable rate of the national currency as its official goal, while in its reports, the Chinese regulator underscores the priority of ensuring price stability and has been ‘informally’ targeting inflation since 2002, according to BIS estimates.
- Third, the authors review a very specific and short period of time.
A storm lifts all boats: price spikes resulting from supply shocks cannot be avoided by any country, regardless of whether it has adopted the IT regime or not.
Like any other monetary policy framework, the IT regime does not guarantee a constant inflation rate at every moment in time. This is an inherently unachievable objective as monetary policy affects the economy with considerable and changing time lags. Over the medium- and long-term horizon, IT, coupled with other policies (fiscal rule, macroprudential policy), is an effective tool to ensure macroeconomic stability. For example, in the second chapter of its October World Economic Outlook, the IMF provides the results of a large-scale survey confirming the importance of IT, as well as other components of a robust policy regime, as fundamental factors to ensuring macroeconomic stability. In the report, the IMF infers that a transition to IT has also boosted the potential to absorb external shocks and stabilise the macroeconomic environment for emerging market economies that are historically more vulnerable to such shocks.
And the authors themselves, Patrick A. Imam and Tigran Poghosyan, highlight that their findings should not be interpreted as a rejection of IT : Rather, they ‘point to the value of reflecting on how the framework performs in an environment where supply-side forces play a more prominent role in driving inflation.’ Their conclusion is that IT has proven its worth in an environment where inflation is fuelled by demand and would benefit from its additional adaptation to a world where supply-side shocks are becoming more frequent and persistent.
Adaptation to a new world
In both theory and practice, a strict IT framework requires raising policy rates in response to an increase in expected inflation. An acceleration in current price growth and a resulting uptick in expected inflation can be due to both supply- and demand-side shocks. Differentiating these types of shocks is important because demand shocks make inflation and output move in the same direction (both indicators either grow or decline). In this scenario, tight monetary policy amid accelerating inflation and GDP growth above the norm makes it possible to return both of the variables to an equilibrium, achieving the so-called ‘divine coincidence’.
The effects of supply shocks are different. Specifically, rising costs lead to price growth, thus reducing demand and incomes. Consequently, inflation and GDP trends diverge: inflation is accelerating, whereas GDP is decreasing. In such a situation, stabilising inflation through tight monetary policy would require a reduction in output in addition to the one that has already been caused by the supply-side shock. If a supply shock is short-term and reversible (e.g. a single year of poor harvest), then a full-scale monetary policy response, taking into account its time lags, might amplify the economy’s deviation from its balanced long-term dynamics. However, a persistent supply shock (e.g. a permanent global harvest decline due to climate change) entails the loss of potential GDP, and monetary policy should adapt the level of demand to this new reality. If, in this particular case, a central bank decides to overlook its mandate to maintain price stability, this will result in spiralling inflation, rather than in recovering output, which will necessitate tighter macropolicy in the future.
IT based on a rule requiring 1) tightening monetary policy when inflation accelerates and 2) actively communicating this rule and its underlying principles to the public is exactly what helps anchor inflation expectations. Transitory supply shocks cause a temporary surge in inflation, but the latter has no second-round effects, i.e. it does not affect inflation expectations, and they do not grow as both households and businesses assume that the central bank will take prompt efforts to return inflation to a low level. Since inflation expectations do not increase, the need to tighten monetary policy is less pronounced than in a situation where price spikes make economic agents fear persistently high inflation.
If IT-regime preserves anchored inflation expectations during supply shocks, thus making it possible to avoid rate hikes, why did IT countries have to raise their policy rates?
The reason lies precisely in the scale and duration of such shocks. As the IMF economists rightly note in their article, this was an extraordinary period with multiple episodes of rising costs. In some cases, they overlapped with positive demand shocks (growing government expenditure). The IT response, which for several quarters following the inflation surge was based on the assumption that this surge was merely transitory and would subside once the supply shock abated, proved to be insufficient. Why? Because the supply shocks did not abate.
It is widely acknowledged that many central banks, including the largest ones such as the US Fed and the ECB, ‘missed’ (link in Russian) the onset of the post-COVID price hike, mostly because it started off as a typical transitory supply-side shock. In his research paper, Willem H. Buiter, former member of the Monetary Policy Committee of the Bank of England and former chief economist at the EBRD, notes that this assumption was not initially without grounds as supply chain disruptions caused by the pandemic, military conflicts, or natural disasters are usually transitory. Moreover, central banks of advanced economies feared hampering the post-pandemic economic recovery, which started in 2021, coinciding with the beginning of the price growth acceleration. In addition, the previous decade of excessively low inflation, which had become a major problem (link in Russian) for advanced economies, increased the tolerance of their monetary authorities for inflation above the target.
Initially misjudging the reasons behind the post-COVID inflation surge created risks of inflation expectations becoming unanchored. Central banks of advanced economies only started tightening their monetary policies when inflation was already extremely high. This delay, as MIT professor Kristin Forbes and her co-authors argue (link in Russian) in their study, led to a significant increase in the price level, causing public discontent.
On the contrary, emerging economies, with a historically more recent experience of high inflation and more modest estimates of confidence in their monetary policies, and therefore, paying greater attention to supply shocks than advanced economies, raised their policy rates faster and more decisively. According to one study (link in Russian), their communications also proved to be far more efficient.
Supply shocks are very likely to become a ‘background’ for the world economy as many adverse supply-side changes with long-term consequences have been accumulating for years. This includes demographic changes (shrinking labour supply due to an ageing population, which is also a supply-side shock), the ongoing deglobalisation and fragmentation of the global economy, climate change, and the green transition. Claudio Borio, former head of the BIS Monetary and Economic Department, notes that systemic risks to macroeconomic stability, at least the medium-term ones, also include the unsustainability of fiscal trajectories (the inability to stabilise the public debt to GDP ratio amid current budget deficits) in a number of major economies.
Forecasting that there will be more proinflationary drivers in the world economy in the future than there were in the 1990s–2010s, Claudio Borio argues that central banks should treat the main monetary policy objective, i.e. the commitment to low inflation, with greater diligence and reverence. This means that the practical implementation of IT should factor in the changing environment for monetary policy to remain efficient under various economic scenarios.
Discussing the need for such adaptation to permanent supply shocks, Gita Gopinath, former first deputy managing director of the IMF, also emphasised that the commitment to price stability should remain the key strategy for central banks, as it is crucial for sustained economic growth to reach its full potential. According to Gita Gopinath, this strategy will require central banks to become more resolute and proactive when responding to increasing price pressures, to maintain tight monetary policy for longer periods, and to be ready to rapidly change the policy direction if the totality of indicators confirm that the disinflation trend is stable.
Considering that the need to adapt the IT framework to the new reality where supply shocks are becoming permanent, persistent, and significant has become a popular topic of discussion in recent years, other potential solutions include improving the analytical and forecast database, increasing the targeting horizon (i.e. assuming a longer period of disinflation, which is, nevertheless, highly debatable in terms of the anchoring of inflation expectations), and more efficient fiscal policy (which, unlike monetary policy, can affect a number of structural supply-side constraints).
Conclusions for Russia
The 2021–2023 global inflation experience serves as a clear lesson that a poor analysis of price dynamics, their overly lax interpretation, and an untimely monetary policy response to persistent supply shocks lead to a more considerable surge in prices, which is in line with the predictions of the conventional macroeconomic theory.
Having read the IMF paper comparing the responses of IT and non-IT countries to inflation in the post-pandemic period, certain Russian experts, for some reason, concluded (link in Russian) that the Bank of Russia should start cutting the key rate, as well as abandon the IT framework and the inflation target altogether. This interpretation seems to be not just lax, but fundamentally incorrect, as it is based on the straw man fallacy and ignores the nature of current inflation in Russia.
Firstly, the IMF study we examined compares the relative effectiveness of different monetary policy regimes instead of the absolute effectiveness of the policy rate tool. On the contrary, it demonstrates that both IT and non-IT countries actively raised policy rates to combat inflation. Moreover, those countries that started to do so earlier managed to curb inflation sooner. Secondly, the research concerns the episode where inflation was primarily caused by supply shocks. While this was true for Russia in 2022, data indicate that the price growth acceleration since 2023 H2 has mostly been demand-driven. The way to combat this is by limiting excessive demand growth through maintaining high levels of not only nominal, but also real interest rates. In this context, a proposal to cut the key rate and abandon IT is akin to breaking a thermometer to reduce a fever. Thirdly, the IMF working paper shows that in the face of persistent and recurring proinflationary shocks, central banks should lean towards tighter monetary policy, rather than rely on the temporary nature of these shocks.
Tight monetary policy is inherently disinflationary as its impact on demand is much more significant (link in Russian) than that on current production capacities. It is often argued that lowering the key rate may help expand supply and thereby lower inflation. However, economic realities prove to be different: demand responds to a premature easing of monetary policy much faster than supply does.
The factors limiting supply expansion are related to the availability of physical resources, i.e. labour, physical capital, and technology, rather than to the amount of money or credit affordability. All available labour resources are already being utilised in the Russian economy. Currently, the unemployment rate is a mere 2.2%, which is a record low for Russia and a very low level by global standards. The accumulation of physical capital does not happen fast. Over recent years, the increase in fixed capital investment has outpaced GDP growth, with the share of investment in GDP also rising significantly.
Supply expansion amid limited physical resources can be achieved by means of labour productivity growth. However, this growth is determined not only, or even mainly, by new machines and new roads, but by the institutional environment, i.e. regulation, incentives for innovation, labour market flexibility, employees’ motivation to enhance their competencies and choose to work in those industries and economic sectors where their expertise and skills are most in demand, thus allowing them to make a greater contribution to the added value, that is to GDP. Certainly, the increase in labour productivity is also largely contingent on macroeconomic stability and predictability.
Accommodative monetary policy amid rising inflation will only make the situation in the economy more unstable and less predictable, materialising the risks of spiralling and uncontrollable inflation. The expectations that one could ensure long-term miraculous economic growth results in an environment of chronically high inflation run counter to the experience of many countries. Ultimately, bringing inflation down from very high levels will come at a far greater cost and is very likely to entail a serious economic recession.
