Monetary Policy under Test

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Monetary Policy under Test

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Bibliographic details

• Authors: CLAUDIO BORIO
• Published: March 1, 2023

Central challenge

• Central banks must balance fighting inflation and maintaining financial stability for the first time in decades.
• Tension: bringing inflation back to target (tightening) versus stabilizing the financial system if stresses emerge (easing).
• Timing context: article dated March 2023; assessment refers to conditions "at the time of writing, in mid-February 2023."

Drivers of the recent inflation surge

• COVID-19 crisis role (three reasons):
  • Global aggregate demand rebounded with surprising strength in 2021—both as a natural sequel to its artificial suppression during the lockdowns and bolstered by unprecedented fiscal and monetary policies designed to support business activity and household incomes.
  • The pandemic-induced shift in global demand from services to goods was unexpectedly persistent, which put global supply chains under huge pressure, causing bottlenecks.
  • Global supply in general could not keep up. Commodity price increases, which individual countries tended to treat as “supply shocks,” reflected to an important extent global demand pressures.
• The Russian invasion of Ukraine in February 2022 pushed energy and food prices to new highs.
• Macroeconomic models failed to anticipate the inflation path because they were estimated over a long period of low and stable inflation and typically assumed inflation would return to target—about 2 percent.

Two-regime view of inflation (key analytical insight)

• Inflation modeled as a two-regime process: a low-inflation regime and a high-inflation regime, with self-reinforcing transitions from low to high.
• Characteristics of the low-inflation regime:
  • Price changes mostly reflect sector-specific movements that are only loosely correlated.
  • Wages and prices are only loosely linked.
  • Inflation has self-stabilizing properties.
• Characteristics of the high-inflation regime:
  • The common component of price changes is much greater.
  • Wages and prices are more tightly linked.
  • Inflation is especially sensitive to salient prices (food, energy) and exchange-rate fluctuations.
• Self-reinforcing mechanisms for regime shifts:
  • Inflation moves out of the zone of rational inattention and becomes focal for business and individual decisions.
  • Increased synchrony in price changes raises the probability of wage-price spirals.

Monetary policy response and its limits

• Central banks responded forcefully once the persistence and strength of inflation were recognized.
• This has produced "the most synchronized and intense shift to monetary tightening since World War II" when measured in terms of nominal interest rates.
• Real rates have moved less and remain relatively low.
• As of mid-February 2023, central banks were raising interest rates more slowly, but the fight against inflation was described as "far from over."
• The "last mile" of returning to a low-inflation target may be the hardest to travel.
• Risk of inaction: failing to act forcefully may reduce near-term costs but raise long-term costs because more entrenched inflation will be harder to vanquish.
• Definition recalled: price stability as described by Paul A. Volcker and Alan Greenspan—where inflation does not materially influence the behavior of economic agents.

Financial-stability risks amid tightening

• Banks are in better shape than in the run-up to the Great Financial Crisis of 2008, aided by regulatory reforms; during the COVID crisis, banks were part of the solution.
• Concerns remain because:
  • Debt levels are historically high.
  • Assets are richly valued, exposing lenders to potential substantial losses on loans and other exposures to firms and households.
  • Unknowns include potential losses from banks’ direct and indirect exposures to nonbank financial intermediaries.
• Nonbank financial intermediation sector vulnerabilities:
  • Has grown massively since the Great Financial Crisis.
  • Growth partly resulted from regulatory reforms shifting risk from banks to nonbanks.
  • The sector is described as "rife with hidden leverage and prone to funding stress."
  • Risky behavior increased during the long phase of exceptionally low interest rates.
  • Progress on developing an adequate regulatory framework for the sector has been disappointing; there is an urgent need to speed it up with a macroprudential focus.
• Recent example episodes signaling vulnerabilities:
  • The collapse of Archegos Capital Management in September 2021, which caused surprisingly large losses to banks.
  • The "dash for cash" at the onset of the COVID-19 pandemic, which triggered severe problems in sovereign debt markets after investors dumped government securities.
  • The turmoil in the British government bond market in October 2022, when pension funds sold off bonds (gilts) as a budget crisis loomed.
• These episodes "could represent the proverbial canary in the coal mine."

Public debt and sovereign backstop concerns

• High public sector debt is highlighted as a potentially bigger long-term issue than high private-sector debt.
• The sovereign is the ultimate backstop of the financial system and can tackle solvency problems that the central bank cannot.
• When inflation began to increase in 2021, global public sector debt had reached a historical high, "in line with the World War II peak."
• In 2021, interest rates were at historical lows, making the debt service burden feel light and incentivizing governments to keep borrowing.
• Rough calculations suggest that if rates return to the mid-1990s levels, the debt service burden would, on average, climb to a level similar to its World War II peak.

Policy implications and recommendations

• Central banks need to act forcefully to prevent a transition from a low- to a high-inflation regime; delaying action risks larger costs later.
• Regulatory priority: speed up development of an adequate framework for the nonbank financial intermediation sector with a macroprudential focus on the stability of the financial sector as a whole.
• Vigilance required on public finances given the interaction of higher interest rates with historically high public debt.

Claudio Borio, "Monetary Policy under Test", F&D Magazine, March 2023.