Since the onset of Covid-19 and the Ukraine war, the Phillips curve relationship between economic slack and inflation has steepened. Understanding whether this steepening is temporary or permanent is key to assessing how much growth and employment need to be 'sacrificed' to tame inflation.

At the abrdn Research Institute, we use a comprehensive global modelling framework to assess the contribution of a broad range of cyclical and structural inflation factors. We take account of variations across emerging and developed economies, as well as goods and service sectors.

Key drivers

We find that expectations and lagged inflation are the most important drivers of inflation outcomes. In particular, core goods inflation is very sensitive to expectations and slack. Core services is more influenced by lagged inflation and local labour markets. We also find that emerging economies are more sensitive to shocks to global value chains than advanced economies.

Prior to the pandemic, globalisation and innovation combined to flatten the Phillips curve. Today, ongoing innovation should help offset some of the inflationary pressures from increased reshoring trends.

We also find that demographic trends such as ageing populations have a positive influence on inflation, but are statistically weak relative to other drivers.

Ultimately, it's central bank credibility that anchors inflation expectations

While the above structural drivers are important, they act as multi-year headwinds or tailwinds that central banks must navigate to deliver their policy objectives. Ultimately, it's central bank credibility that anchors inflation expectations and determines the price level over the long-run.

In conclusion

Given the current degree of inflation overshoot, we believe a recession is likely necessary to restore inflation to target and re-establish central bank credibility. The alternative would be sustained stagflation.

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