Subscribe to receive free updates from Central banks. We’ll send you a myFT Daily Digest email every morning with the latest news on Central banks. In high-income countries, consumer price inflation is currently at its highest level in forty years. As a result, interest rates are also rising. The era of “low for long” is no longer applicable, at least for now. So, why did this happen? Will this change last? And what should the policy response be?
The Bank for International Settlements (BIS) has consistently provided a unique perspective on these issues compared to other international organizations and central banks. Over the past twenty years, they have highlighted the risks associated with ultra-easy monetary policy, high debt levels, and financial fragility. While I may not agree with all aspects of their analysis, I have always found their insights valuable. In their Annual Economic Report, they offer a thorough analysis of the current macroeconomic environment.
The report acknowledges the current situation as one with “high inflation, surprising economic resilience, and signs of stress in the financial system.” While there is a widely held belief that inflation will eventually decrease, the report points out that over 60% of items in the consumption basket in high-income countries have experienced annual price rises of over 5%. Additionally, real wages have significantly declined during this inflationary period. The report argues that it is reasonable to expect wage earners to try to catch up, especially considering the tight labor markets. However, this could result in a distributional struggle rather than sustained inflation.
The challenges of calibrating policy responses are further complicated by financial fragility. The Institute of International Finance reports that global gross debt levels are 17% higher compared to the period just before the collapse of Lehman Brothers in 2008, despite post-Covid declines. Rising interest rates and potential bank runs have already caused disruptions, and institutions exposed to property, interest rate, and maturity risks are likely to face further problems. Higher borrowing costs will also impact households over time, and banks with low equity prices will struggle to raise capital. The state of non-bank financial institutions is even more uncertain.
The combination of inflationary pressures and financial fragility poses a unique challenge that was not present in the 1970s. The BIS suggests that navigating the final stage of disinflation could be the most difficult, not just economically but also politically. While the BIS does not explicitly mention populism as a concern, it should be acknowledged as a potential consequence.
The question of how we reached this situation is complex. We are familiar with the post-Covid supply shocks and geopolitical tensions, such as the war in Ukraine. However, the BIS argues that the massive monetary and fiscal stimulus deployed during the pandemic was excessive in terms of size, breadth, and duration. I agree with this assessment. Financial fragility also built up over the years of low interest rates. Where I differ from the BIS is whether the prolongation of “low for long” could have been avoided. The Bank of Japan and the European Central Bank attempted to change this narrative in the past but were unsuccessful.
The question of whether the current shift in the monetary environment is temporary or enduring remains uncertain. It depends on the extent to which high inflation is a result of supply shocks and whether societies accustomed to low inflation find it too painful to bring it down. The fragmentation of the global economy and the potential persistence of ultra-low real interest rates also play a crucial role. If the era of ultra-low real interest rates is not over, the current situation could be a temporary blip. However, if it is over, significant challenges lie ahead as higher real interest rates make current levels of indebtedness unsustainable.
In terms of policy response, the BIS emphasizes the importance of structural measures over fiscal and monetary policies. They argue that we have relied too heavily on the latter and not enough on the former, leading to an unstable economic region where expectations, including inflation, are not self-stabilizing. The BIS’s distinction between how individuals behave in low inflation and high inflation environments is valuable. The decisions made in the coming years will be crucial in determining the trajectory of our economies. Therefore, central banks must demonstrate courage.
While I appreciate the BIS’s insights, I am not fully convinced by all aspects of their standpoint. For example, they contend that policymakers should have been more relaxed about persistently low inflation. However, this could have rendered monetary policy ineffective during severe recessions. They also argue that macroeconomic stabilization is not as important, but extended periods of recessions and high inflation are equally undesirable. Furthermore, a stable macroeconomic environment is beneficial for growth as it facilitates business planning.
Above all, I remain unconvinced that financial stability should be the primary goal of monetary policy. Keeping economies perpetually weak to prevent a blow-up in the financial sector is not a valid argument. If financial instability is a concern, then direct measures targeting it should be implemented. This could include eliminating the tax deductibility of interest, imposing stricter penalties on individuals responsible for bankrupt financial institutions, and ensuring effective resolution procedures for failed institutions.
Despite any disagreements, the BIS always brings crucial issues to the forefront for consideration. Their insights are valuable, even when there is not complete alignment with their perspectives.
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