Looser Financial Conditions Pose Conundrum for Central Banks

IMF Blog, February 2, 2023

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Authors: Tobias Adrian, Christopher Erceg, Fabio Natalucci
Date: February 2, 2023
Core message: Despite sharp monetary policy tightening, financial conditions have eased around much of the globe, creating a challenge for central banks that must choose between accepting market optimism about rapid disinflation or maintaining restrictive policy until disinflation is convincingly durable.

Factors driving the inflation surge during the pandemic recovery included supply disruptions, high energy prices following Russia’s invasion of Ukraine, and massive monetary and fiscal stimulus that fueled spending on housing and durable goods.
Inflation topped 6 percent in more than four-fifths of the world’s economies.
Central banks in emerging markets responded by sharply tightening policy beginning in 2021, followed by their counterparts in advanced economies.
Result: a tightening of financial conditions globally through the fall of last year and an expectation that global economic growth is now expected to slow this year.

Falling energy prices have reduced headline inflation and fueled optimism that monetary policy may be eased later this year.
In some economies, prices for goods included in core inflation measures, such as autos and furniture, have fallen.
In the United States and the euro area, market-based measures of inflation one year ahead have returned to near the central banks’ 2 percent target from 6 percent last spring.
In emerging markets, market-based measures of inflation one year ahead have also been falling, albeit at a slower pace.
Financial-market effects of this optimism:
- Yields on long-dated government debt in many economies have fallen below short-dated maturities (yield-curve inversion).
- Stock markets have rallied.
- Credit spreads narrowed considerably.
Market-implied narrative: a so-called soft landing—disinflation with little cost to economic growth; analyst assessments nevertheless point to significant recession risk in many economies, with the expectation that recessions, should they occur, will be mild.

Two policy paths:
- Embrace market optimism and effectively ratify loosening financial conditions, risking premature easing.
- Push back against investor optimism and maintain restrictive interest rates until there is tangible evidence of sustained disinflation.
Rationale for the risk-management approach (maintain restrictive policy longer):
- History shows high inflation is often persistent—and may possibly ratchet up further—without forceful and decisive monetary policy actions to reduce it.
- While goods inflation has come down, it seems unlikely that the same will happen for services without significant labor-market cooling; central banks must avoid easing policy before services inflation and wages have moderated markedly.
- Prolonged periods of rapid price gains make inflation expectations more susceptible to de-anchoring as an inflationary mindset becomes entrenched in the behavior of households and firms.

Central banks should communicate the likely need to keep interest rates higher for longer until there is evidence that inflation—including wages and prices of services—has sustainably returned to the target.
Policymakers will likely face pressure to ease policy as unemployment rises and inflation keeps falling; these pressures could be particularly acute for emerging market economies.
Acknowledge uncertainty: this is an unusual period with many special factors affecting inflation, and it is possible that inflation comes down more quickly than policymakers envision.
Warning: loosen prematurely could risk a sharp resurgence in inflation once activity rebounds, leaving countries susceptible to further shocks which could de-anchor inflation expectations.
Conclusion: it is critical for policymakers to remain resolute and focus on bringing inflation back to target without delay.

Source: Looser Financial Conditions Pose Conundrum for Central Banks — Tobias Adrian, Christopher Erceg, Fabio Natalucci; February 2, 2023.