Three Uncomfortable Truths For Monetary Policy
IMF News, June 26, 2023
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- Published: June 26, 2023
Introduction
- Remarks delivered by IMF First Deputy Managing Director Gita Gopinath for the European Central Bank Forum on Central Banking 2023 on June 26, 2023.
- Central message: central banks must confront three “uncomfortable truths” while fighting persistent high inflation and considering future strategy changes.
Uncomfortable Truth #1: Inflation is taking too long to get back to target
- Findings
- Headline inflation has declined, but stickier components remain persistently high.
- Inflation sits well above previous forecasts; markets remain optimistic that inflation will recede quickly despite repeated forecast errors.
- Inflation in services has stayed high; the date by when it is expected to return to target could slip further.
- Factors behind persistent inflation (II.A)
- The ECB has raised interest rates during the past year by 400 basis points—the most in its history—yet activity has only slowed modestly.
- Unemployment rate is at historic lows.
- Wage growth has been solid and is picking up, though not by enough to begin reversing sharp declines in real wages over the past two years.
- Tight labor markets, solid household savings, and residual pent-up demand may be supporting resilient activity.
- Real rates using market-based measures of inflation expectations are still quite low; near-term real rates using household measures are likely negative.
- The pandemic has likely lowered potential output and productivity, contributing to upward pressure on inflation.
- Risk: sustained high inflation could change inflation dynamics via wage catchup and resistance by firms to compress profit margins.
- Role of fiscal policy (II.B)
- Fiscal tightening could help cool demand and reduce the need for rising interest rates, especially if done in concert by a broad group of countries.
- Euro area governments should resist diluting projected deficit reduction under current policies.
- Where support is needed, shift from broad-based to well-targeted support; revenue windfalls from high inflation should be saved.
- Appropriate policy strategy (II.C)
- Central banks should continue to tighten and then remain in restrictive territory until core inflation is on a clear downward path.
- Be prepared to react forcefully to further upside inflation pressures, even if that means much more labor market cooling.
- Stay vigilant for downside risks from unwinding supply disruptions and falling energy prices; be prepared to adjust course if indicators show materializing downside risks.
Uncomfortable Truth #2: Financial stresses could generate tensions between price and financial stability objectives
- Core contention
- If inflation persists and central banks tighten more than markets expect, modestly tight financial conditions could rapidly reprice assets and raise credit spreads.
- Financial stresses could create tensions between price stability and financial stability because central banks can provide liquidity to solvent banks but cannot address insolvent borrowers without fiscal action.
- Policy response to modest financial stress (III.A)
- If stresses remain modest, central banks can lower policy rates to support output and inflation and use liquidity facilities (e.g., discount window).
- Communication is crucial because lowering rates can be misinterpreted as weakening resolve on inflation.
- When stress threatens systemic crisis (III.B)
- Forestalling a crisis may require sizeable fiscal resources; central banks are limited in addressing insolvent banks, firms, or households.
- Forceful, timely interventions backed by fiscal support can allow monetary policy to focus on price stability (“separation”), but this depends on available fiscal space and political support.
- If governments lack fiscal capacity, central banks may tolerate a somewhat slower return to the inflation target to avert systemic stress, but the bar should be high.
- Steps to strengthen the EU framework (III.C)
- ECB actions include the Transmission Protection Instrument to guard against sharp divergences in borrowing costs across countries.
- EU-wide measures already in place: application of Basel III capital and liquidity requirements to all banks; capital and liquidity ratios of the banking system as a whole are solid.
- Near-term: continue enhanced risk assessments and bank stress-testing (EBA-ECB bank stress tests).
- Ensure prudent public debt paths and finalize reform of the EU economic and fiscal governance framework.
- Strengthen pan-European institutions (e.g., European Stability Mechanism, Single Resolution Fund) and make meaningful progress toward a European deposit insurance scheme.
- Make the EU crisis management and bank resolution framework more flexible (possibly include a systemic risk exception).
- Further progress on capital markets union to deepen capital markets and reduce fragmentation risk.
- Macroprudential: strengthen capital buffers; banks should save some of their current high profits as capital; expand the macroprudential toolkit for nonbank financial intermediaries.
Uncomfortable Truth #3: More upside inflation risks than before the pandemic
- Central claim
- Central banks are likely to face more upside inflation risks going forward; monetary policy strategies and tools like forward guidance and QE need refining.
- Sources of more upside risk (IV.A)
- Structural changes: pandemic and the war in Ukraine may have increased volatility of supply shocks and lowered resilience due to restructuring of global supply chains and geo-economic fragmentation.
- Many countries increased restrictions on trade and FDI during the pandemic, raising production costs and susceptibility to supply-side shocks.
- Increasing physical and transition risks from climate change likely amplify short-term fluctuations in inflation and output; delays in achieving Paris Agreement goals raise risk of a disorderly transition and energy disruptions.
- The Phillips Curve is not reliably flat; nonlinearities may become pronounced at high levels of resource utilization, making inflation more sensitive to resource pressures.
- Difficulties measuring economic slack make it harder to gauge when inflationary pressures will escalate.
- Implications for policy strategy (IV.B)
- Be more cautious about “looking through” supply shocks; react more aggressively if shocks are broad-based or inflation has been running above target.
- Consider preemptive tightening where resource pressures appear tight even if inflation is modestly below target.
- Recalibrate “lower-for-longer” strategies: they may still be appropriate in deep recessions with chronically low inflation, but be cautious about aiming to run unemployment persistently below the natural rate U* when inflation is modestly below target (e.g., between 1.5 percent and 2 percent).
- A more gradual pace of tightening with preemptive action can reduce financial stability risks associated with a rapid exit from low rates.
- Refining the use of tools (IV.C)
- Forward guidance can be helpful, but conditional promises should include escape clauses to avoid straitjacketing policy responses.
- Reassess the costs and benefits of QE: QE remains critical when unemployment is high and inflation low with policy rates at the floor, but be wary of using QE and promising low policy rates when employment has largely recovered and inflation is only modestly below target.
- Maintaining QE outside of recession risks overheating and forcing a sharp U-turn in policy.
Conclusion
- Three central takeaways:
- Inflation remains sticky and is taking too long to return to target.
- Financial stresses could complicate the balance between price and financial stability; “separation” via fiscal-backed interventions is possible but not guaranteed.
- More frequent upside inflation risks imply a need to refine monetary policy strategies, forward guidance, and QE use.
- Final note: while the battle against inflation will be difficult and may require slower growth, central bank actions can restore price stability.
Remarks by IMF First Deputy Managing Director Gita Gopinath for the European Central Bank Forum on Central Banking 2023, June 26, 2023.