## NEW DIRECTIONS FOR MONETARY POLICY

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**Canonical URL:** [NEW DIRECTIONS FOR MONETARY POLICY](https://www.imf.org/-/media/files/publications/fandd/article/2023/march/gopinath-crisis-monetary-policy.pdf)

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### Accounting for the inflation surge
- The global inflation surge followed a unique confluence of crises: the global pandemic and Russia’s invasion of Ukraine.
- Precrisis empirical evidence suggested a very flat Phillips curve: inflation rose by only a small amount when unemployment declined.
- Models embedding a low Phillips curve slope did a poor job of explaining the pandemic-related surge in prices; most inflation forecasts based on these models, including IMF forecasts, significantly underpredicted inflation.
- Possible explanations for forecasting failure:
  - "Speed effects": the rapid employment recovery may have played a significant role in driving inflation, implying speed effects matter more than previously thought.
  - Nonlinearities in the Phillips curve slope: price and wage pressures from falling unemployment become more acute when the economy is running hot than when it’s below full employment.
  - Sectoral capacity constraints: surging goods inflation during the recovery—when constraints on supply and demand for services meant massive stimulus fell heavily on goods—suggests sectoral as well as aggregate capacity constraints matter.

### Lessons for monetary policy
- Need for better aggregate supply models that reflect the pandemic’s lessons:
  - Further develop sectoral models that differentiate between goods and services and incorporate sectoral capacity constraints to account for speed effects and nonlinearities.
- Reconsider pre-pandemic policy prescriptions based on a flat Phillips curve:
  - The prior prescription that unemployment well below its natural rate was acceptable may be riskier than thought; running the economy hot had appeared to work pre-pandemic but can raise inflation risks significantly.
  - Measurement difficulties of economic slack matter more if the Phillips curve is nonlinear when unemployment falls below a highly uncertain natural rate—policymakers may unwittingly push unemployment below optimistic natural-rate estimates and fuel an inflationary surge.
  - Running the economy hot increases the likelihood that key sectors will hit capacity constraints, generating inflationary pressures that may become broad-based.
- Rethink "look-through" responses to supply shocks:
  - Pre-pandemic view: major central banks could "look through" temporary supply shocks and assume inflation would be transient, reacting primarily to second-round effects.
  - Pandemic experience: supply shocks can have broad, persistent inflationary effects with surprising speed—pressures can spread through supply chains, to wages, or affect inflation expectations.
  - Implication: central banks should react more forcefully under certain conditions:
    - When initial inflation is already high, looking through a shock risks dislodging price expectations.
    - In a strong economy where producers can pass on rising costs and workers resist real wage declines.
    - When shocks are broad-based rather than concentrated in particular sectors.

### Risk of persistence
- Two central risks post-crises:
  - High inflation de-anchoring expectations, complicating monetary policy trade-offs; currency depreciations and supply shocks would have much more persistent inflationary effects.
  - More chronic disruptions to global supply chains and increased trade barriers could raise supply shock volatility and make stabilization harder.
- Emerging markets vulnerability:
  - Central banks in emerging markets would be particularly hurt if trade becomes more fragmented and inflation expectations de-anchor; these economies are already more vulnerable to external shocks and could face harder policy trade-offs.
- Potential long-run demand-side effects on the equilibrium real interest rate:
  - The pandemic and war could affect inequality, demographics, productivity, demand for safe assets, public investment and debt, among other things.
  - These effects could further depress the equilibrium rate by increasing demand for safe assets and raising inequality.
  - Overall, these effects probably won’t be particularly large, and, accordingly, the equilibrium rate is likely to remain low—though there remains uncertainty about its actual level.
  - Countervailing possibility: a persistent shift to deficit spending, or a sizable catch-up in climate investment, could materially boost the equilibrium rate.

### Policy implications and recommendations
- Monetary policy stance:
  - Central banks must account for risks of inflation being too low or too high and for stronger tensions between price stability and employment or growth.
  - Given the more palpable risk of rapid inflation, revisit robustness of strategies such as running the economy hot and seeing supply shocks as temporary.
  - Advanced economy central banks need to stay the course and maintain restrictive monetary policy rates until they see durable signs of inflation returning to target.
  - "We can’t have sustained economic growth without restoring price stability."
- Complementary policies:
  - Fiscal policy should provide targeted help for the most vulnerable that doesn’t stimulate the economy.
  - Policymakers must advance the climate agenda to preserve economic and financial stability.
  - Policies that reduce fragmentation risks in global trade will lower the risk of supply shocks and help boost the world’s potential output.

*March 2023 — GITA GOPINATH, First Deputy Managing Director of the IMF*

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_Source: https://www.imf.org/-/media/files/publications/fandd/article/2023/march/gopinath-crisis-monetary-policy.pdf_