Particularly in small open economies, where shocks to the exchange rate and other shocks from abroad have a significant impact on inflation, it is quite likely that the generation of inflationary potential may initially translate into asset price growth or, in some cases, current account deficits rather than into overt CPI inflation. The latter may then stay quite low for a long time even when the economy is overheating. As a result, rather than inflation-forecast targeting, central banks may slide towards a response-torecent-inflation-numbers regime. What is the solution to this situation? I offer no simple one. The above dilemmas need to be reflected in our thought processes. In monetary policy decision-making, in addition to model-based forecasts of highly variable CPI inflation, we need to give equal weight to the longer-term fundamental inflationary pressures generated by macroeconomic, monetary and financial developments. I understand the arguments that we have no reliable indicator of these pressures and that few people outside the central bank itself would pay heed to an index of fundamental inflationary pressures. But you can't escape reality. It doesn't pay to put everything on one card. It's better to have a broader set of models and, on top of that, a set of indicators to allow for cross-checking. From fears of low inflation to the current inflation shock For a quarter of a century, central banks in developed countries, along with legions of renowned macroeconomists, focused almost exclusively on how to prevent inflation from getting too low. At certain times, this undoubtedly made sense.
State-of-the-art NK-DSGE approaches introduced rigour and strong microeconomic foundations into macroeconomic thinking. They became an important tool for simulating the effects of monetary policy and other macroeconomic shocks. But nothing is for free. The positive features of this framework came at the cost of what is described as a high degree of model stylisation. Put simply, these models, especially at their beginnings, were very narrow in terms of the specification of the economy and its behaviour, and omitted a number of important linkages and processes. Despite much progress in the academic literature over the last 10 years, the variants used by central banks remain suitable mainly for analysing small deviations of macroeconomic variables from their long-term trends. They represent a highly imperfect description of the economy and are not able to cope with shocks or structural changes that deflect it from these trends for lengthy periods. The macroeconomic instability we have seen over the last 20 years is essentially inconceivable in these models. Despite these limitations, NK-DSGE models have for quite some time been strongly dominant in academic macroeconomics and been the main tool used for analysis and forecasting in some central banks. In a scientific discipline in which scholars have always held different views and argued heatedly among themselves, such a situation was by definition strange. It is good that after the GFC, the fundamental debate on different approaches to macroeconomic modelling was revived and the seemingly irreconcilable camps were able to reach some common conclusions.