Global economy at risk of falling into permanent high inflation trap

The price of groceries could surge by £1.7bn due to the cost of carbon dioxide rising by as much as 3000%, new analysis has shown.

The global economy is at risk of falling into a permanent high inflationary trap that will be difficult to “dislodge” as workers and companies chase rising prices, the Bank of International Settlements has warned.

In its latest annual report on the state of the world economy, the so-called “central bank of central banks” warned there was now a greater danger that interest rates would have to remain high until 2027 to fight against the threat of a “high inflationary regime” becoming permanent in many economies.

“The longer inflation is allowed to persist, the greater the likelihood that it becomes entrenched and the bigger the costs of quenching it,” the institute, based in Basel, said.

The UK was singled out last week by investors and economists as most at risk of tipping into a wage-price spiral, where workers demand better pay deals to compensate for the rising price of goods and services. The UK has suffered from a shrinking workforce after the pandemic and still has the highest rates of headline inflation in the G7.

The BIS pinpointed tight labour markets, where unemployment is low and labour is scarce, as a major source of inflationary persistence. “It would be unreasonable to expect that wage earners would not try to catch up, not least since labour markets remain very tight,” the report said. “Once an inflation psychology sets in, it is hard to dislodge”.

“There is a material risk that an inflation psychology will take hold, where wage and price increases start to reinforce each other. Interest rates may need to stay higher for longer than the public and investors expect.”

Although headline inflation has fallen to a three-year low in the US, and has subsided from double-digit peaks in the UK and the eurozone, measures of underlying core inflation have strengthened by more than expected this year. Core inflation in the UK, which strips out components such as food and energy, is at its highest level since 1992 at 7.1 per cent.

Stubbornly high inflation and rapidly tightening monetary policy raise the cost of servicing government debt burdens and threaten to destabilise the financial system. In March the US suffered its worst bout of banking failures since the financial crisis in 2008, while the UK’s gilts meltdown after last year’s mini-budget was a painful example of how rising borrowing costs can rock parts of the financial system that have long relied on ultra-low interest rates.

Despite the risks the BIS urged central banks to press ahead with aggressive monetary action to break the self-reinforcing cycle of high prices and high wages.

“For central banks, the task is clear. They need to restore price stability” Agustín Carstens, general manager of the BIS and the former governor of Mexico’s central bank, said. “A shift to a high-inflation regime would impose enormous costs. No one would benefit. Higher inflation won’t boost real wages. It won’t deliver growth. It won’t bolster financial stability. And any gains from inflating away public debt would be small, risky, temporary and certainly not exploitable.”

Carstens said it was time for central bankers and governments to be “realistic” about the narrowing chances of achieving disinflation without causing a recession in their respective economies.

The warning comes as the UK Treasury is under pressure to provide relief to mortgage holders facing spiralling repayments this year. The BIS warned, however, that state spending needed to be “systemically” reined in after the pandemic and energy crisis had forced governments into mass emergency splurges.

Carstens said fiscal consolidation was “needed to put unsustainable fiscal trajectories onto a more secure footing. This too would help in the fight against inflation.”