Central bankers face a more challenging economic landscape than they have experienced in decades and will find it harder to eradicate high inflation, top multilateral officials and monetary policymakers have warned.
The world’s leading economic authorities sounded the alarm this weekend about the forces at work against the Federal Reserve, the European Central Bank and other central banks as they battle the worst inflation in decades. At the annual gathering of central bankers in Jackson Hole, Wyoming, many said the global economy was entering a new and tougher era.
“At least over the next five years, monetary policy is going to be much more challenging than it was in the two decades before the pandemic hit,”[ads1]; Gita Gopinath, the IMF’s deputy managing director, told the Financial Times.
“We’re 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 expensive trade-offs for monetary policy,” she said.
The pace of inflation has soared as supply chain disruptions from Covid-19 shutdowns collided with high consumer demand fueled 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 even more supply constraints and price increases.
This dynamic has forced central banks to aggressively tighten monetary policy to ensure that inflation does not become more deeply entrenched in the global economy. But given their limited capacity to deal with supply-related problems, many fear they will be forced to deliver much more economic pain than before to restore price stability.
David Malpass, president of the World Bank, warned that central banks’ tools, especially in advanced economies, are ill-suited to meet the supply-side inflationary pressures that are driving a significant part of the recent rise in inflation.
“The rate hikes have to compete with a lot of friction in the economy, so I think that’s the biggest challenge they face,” he said. “You raise prices in the hope of reducing inflation, but that is countered by so much friction in the supply chain and the production cycle.”
Key figures at both the Fed and the ECB gave “unconditional” promises to restore price stability. Jay Powell, the Fed chairman, warned on Friday that as a result a “sustained period” of slow growth and a weakening of the labor market was likely.
Gopinath warned that the ECB faced particularly acute trade-offs; There was “a real risk” that a stagflationary environment of slowing growth and high inflation will emerge in Europe, given the intensity of the energy crisis caused by the Ukraine war, she said.
Malpass said developing economies are also particularly vulnerable when global economic conditions tighten.
“Part of it is higher interest rates and they have a lot of outstanding debt, so that both increases their debt service costs but makes it harder for them to get new debt,” he said. “The additional challenge is the advanced economies that draw heavily on global capital and energy resources, creating a shortage of working capital for new investment [elsewhere].”
The enormous economic challenge facing central bankers was summed up by Changyong Rhee, head of the Bank of Korea, when he said whether the world would return to a low-inflation environment was the “billion dollar question”.
Cutting through the lively atmosphere among Jackson Hole attendees — who, because of the pandemic, had waited two years to socialize and trade ideas face-to-face — was the overriding concern that the world and the economic relations that underpin it had changed fundamentally.
The sharp shift in economic dynamics led the participants to do some soul-searching. “There is a lot of humility in the room [about] what we know and what we don’t know, Gopinath said.
The event exposed in stark detail the fault lines 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 have profound implications for the world’s economic performance, for the interconnected nature of the world 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 former policymakers.
Complicating matters are doubts about how much policy tightening is necessary in the face of unpredictable fluctuations in supply and, in turn, prices.
“At the moment we have to make our decisions against a background of high uncertainty,” said Thomas Jordan, chairman of the Swiss National Bank. “Interpreting current data is challenging, and it is difficult to distinguish between temporary and persistent inflationary pressures.”
According to the ECB’s Schnabel, the next few years are at risk of being known as “the Great Volatility” – in contrast to the last two decades, which economists called “the Great Moderation” because of the relatively calm dynamics.
Many officials have come to believe that the structural forces that kept price pressures in check – mainly globalization and an abundant labor supply – have reversed.
“The global economy appears to be on the verge of a historic shift as many of the aggregate supply tailwinds that have kept a lid on inflation appear to be turning into headwinds,” warned Agustín Carstens, managing director of the Bank for International Settlements. “If so, the recent uptick in inflationary pressures may prove to be more sustained.”
Skeptics of this view say they are confident that the world’s leading central banks will be able to stave off persistently high inflation.
“The issue central banks need to focus on is not establishing inflation credibility,” said Adam Posen, president of the Peterson Institute for International Economics. “The problem is to change the strategy and the inflation targets for a world where you are going to have more frequent and larger negative supply shocks.”
The 2 percent inflation target that central banks in advanced economies have largely stuck to for decades came up repeatedly throughout the conference, with economists suggesting it may need to be tweaked to suit a more fractured global economy.
Long before the inflation spike, the Fed announced in 2020 that it would target inflation to an average of 2 percent over time, to make up for previous periods of undershooting the target. Last year, the ECB said it would tolerate inflation temporarily rising above 2 percent at times.
Many economists advocated an inflation target of 3 percent. According to Stephanie Aaronson, a former Fed employee 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 get down to 2 percent and you can reduce the amount of low growth you need and also move to a better regime in the long term, because you’re less constrained by the zero lower bound, that seems like a win-win to me,” said Maurice Obstfeld, the former chief economist at the IMF, in an interview.
When and how a central bank such as the Fed and other central banks approach changes in their mandates will be crucial, given their weak control over inflation and the risk that household and business expectations of future price increases could be entrenched.
Karen Dynan, an economics professor at Harvard University who previously worked at the US Federal Reserve, said it would be “very risky” for the Fed and its colleagues to address the issue until they have reined in inflation.
“They have to do everything they can to preserve their credibility — and maybe in some cases restore their credibility — but they have to think hard about what the new goal is going to be.”