Central bankers face a more challenging economic landscape than they have experienced in decades and will find it harder to root out high inflation, top multilateral officials and monetary policymakers have warned.
The world’s leading economic authorities this weekend sounded the alarm about the forces working against the Federal Reserve, European Central Bank and other central banks as they combat the worst inflation in decades. Speaking at the annual gathering of central bankers in Jackson Hole, Wyoming, many said that the global economy was entering a new and tougher era.
“At least over the next five years, monetary policymaking is going to be much more challenging than it was in the two decades before the pandemic struck,” Gita Gopinath, the IMF’s deputy managing director, told the Financial Times.
“We are in an environment where supply shocks are going to be more volatile than we’ve been used to, and that’s going to generate more costly trade-offs for monetary policy,” she said.
The pace of price growth has rocketed as supply-chain disruptions from Covid-19 lockdowns collided with high consumer demand fuelled by unprecedented fiscal and monetary support since the start of the pandemic. Russia’s full-scale invasion of Ukraine delivered a series of commodity shocks that created yet more supply constraints and price increases.
These dynamics have forced central banks to aggressively tighten monetary policy to ensure inflation does not become more deeply embedded in the global economy. But given their limited capacity to address supply-related issues, many fear they will be forced to deliver much more economic pain than in the past in order to restore price stability.
David Malpass, president of the World Bank, warned that central banks’ tools, especially in advanced economies, are ill-suited to address the supply-related inflationary pressures that are driving a significant portion of the recent inflation surge.
“The rate hikes are having to compete with lots of friction within the economy, so I think that’s the biggest challenge that they face,” he said. “You’re hiking rates in the hope of reducing inflation, but it is being counteracted by so much friction within the supply chain and production cycle.”
Key figures at both the Fed and the ECB made “unconditional” pledges to restore price stability. Jay Powell, Fed chair, on Friday warned that as a result, a “sustained period” of slow growth and a weakening of the labour market were likely.
Gopinath cautioned that the ECB faced particularly acute trade-offs; there was “a real risk” that a stagflationary environment of languishing growth and high inflation will emerge in Europe, given the intensity of the energy crisis caused by the Ukraine war, she said.
Malpass said that developing economies were particularly vulnerable as global financial conditions tightened.
“Part of it is higher interest rates and they have a lot of debt outstanding, so that increases both their debt service costs but makes it harder for them to get new debt,” he added. “The added challenge is the advanced economies drawing heavily on global capital and energy resources, creating a lack of working capital for new investments [elsewhere].”
The enormity of the economic challenge confronting central bankers was summed up by Changyong Rhee, head of the Bank of Korea, when he said that whether the world would revert to a low-inflation environment was the “billion-dollar question”.
Cutting through the buoyant atmosphere among Jackson Hole attendees — who, because of the pandemic, had waited two years to socialise and trade ideas face-to-face — was the overarching concern that the world and the economic relationships that underpin it had fundamentally changed.
The sharp shift in economic dynamics left attendees doing some soul-searching. “There’s a lot of humility in the room [about] what we know and what we don’t know,” said Gopinath.
The event revealed in stark detail the faultlines caused by the pandemic and Russia’s invasion of Ukraine.
“We have the energy crisis, we have the food crisis, we have the supply chain crisis and we have the war, all of which has profound implications for the economic performance of the world, for the nature in which the world is interconnected and most importantly, for the relative prices of many, many things,” said Jacob Frenkel, the former governor of the Bank of Israel who chairs the board of the Group of 30, an independent consortium of ex-policymakers.
Complicating matters are doubts about just how much policy tightening is needed in the face of unpredictable gyrations in supply and, in turn, prices.
“Currently, we have to make our decisions against the backdrop of high uncertainty,” said Thomas Jordan, chair of the Swiss National Bank. “Interpreting the current data is challenging, and it is difficult to distinguish between temporary and sustained inflationary pressure.”
According to the ECB’s Schnabel, the next few years are at risk of being known as the “Great Volatility” — in contrast with the past two decades, which economists called the “Great Moderation” because of the relatively tranquil dynamics.
Many officials have come to believe that the structural forces that kept price pressures in check — chiefly globalisation and an abundant labour supply — have reversed.
“The global economy seems to be on the cusp of a historic change as many of the aggregate supply tailwinds that have kept a lid on inflation look set to turn into headwinds,” warned Agustín Carstens, general manager at the Bank for International Settlements. “If so, the recent pick-up in inflationary pressures may prove to be more persistent.”
Sceptics of this view say they are confident that the world’s leading central banks will be able to ward off entrenched high inflation.
“The issue central banks need to focus on isn’t establishing inflation credibility,” said Adam Posen, president of the Peterson Institute for International Economics. “The issue is redoing the strategy and the inflation targets for a world where you’re going to have more frequent and larger negative supply shocks.”
The 2 per cent inflation target that central banks in advanced economies have mostly abided by for decades came up repeatedly throughout the conference, with economists suggesting that it may need to be adapted to fit a more fractured global economy.
Long before the inflation surge, the Fed in 2020 announced it would target inflation at a 2 per cent average over time, in order to make up for past periods of undershooting the target. Last year the ECB said it would tolerate inflation temporarily rising above 2 per cent at times.
Many economists advocated for a 3 per cent inflation target. According to Stephanie Aaronson, a former Fed staffer now at the Brookings Institution, it would give central banks more flexibility to look beyond supply shocks and support the economy during downturns.
“If you’re coming down to 2 per cent and you can shorten the amount of low growth you need and also move to a better regime in the long-run, because you are less constrained by the zero lower bound, it seems to me like a win-win,” said Maurice Obstfeld, the former chief economist of the IMF, in an interview.
When and how a central bank like the Fed and other central banks approach changes in their mandates will be critical, given their tenuous control on inflation and the risk that households’ and businesses’ expectations of future price increases could become entrenched.
Karen Dynan, an economics professor at Harvard University, who previously worked at the US central bank, said it would be “very risky” for the Fed and its counterparts to even broach the topic until they had reined in inflation.
“They need to do everything they can to preserve their credibility — and maybe in some cases, restore their credibility — but they are going to have to think hard about what that new goal should be.”
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