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For the first time in decades, monetary policy must balance inflation fighting and financial stability

Central banks worldwide face an unprecedented constellation of challenges. They are tightening monetary policy to quell inflation when financial markets are stretched and financial vulnerabilities are widespread—mainly from historically high levels of private and public debt and elevated asset prices, especially for property.

Until the mid-1980s, downturns were caused largely by efforts to rein in inflation. And because governments regulated the financial sector tightly, the scope for overt financial fragilities was limited. Since then—with the financial system liberalized and inflation generally low and stable—downturns have typically been caused by financial booms that turned into busts, as during the Great Financial Crisis that began in 2008. The recession that accompanied COVID-19 was one of a kind—the result of policies that put the economy in suspended animation to tackle a health emergency.

The current landscape combines elements of both types of downturn, which greatly complicates monetary policy. Although the economy has become more sensitive to higher interest rates, it is unclear by how much. The effect of a tighter monetary policy on the economy and the financial system is uncertain. One thing is for sure: should financial stresses emerge, the need to bring inflation back to target and to stabilize the financial system would pull in opposite directions—toward tightening to quell inflation and toward easing to relieve financial system stress.

We don’t know for sure why inflation suddenly reemerged, and with such vigor, after being dormant for so long. What we do know is that the COVID-19 crisis played a key role, for 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 did the rest—pushing energy and food prices to new highs.

Macroeconomic models did not anticipate the inflation path. To be sure, shocks are, by definition, unpredictable. But there is more to this. Models were estimated over a long period of low and stable inflation. They tend to assume that inflation will spontaneously return to target—about 2 percent. And they assume that changes in the level of inflation do not influence underlying economic relationships, such as the sensitivity of wages and prices to slack in the economy.

In the latest Bank for International Settlements Annual Economic Report, we offer a different perspective on the inflation process, one that yields a more sobering message. It sees inflation as a two-regime process—a low- and a high-inflation regime —with self-reinforcing transitions from low to high.

Inflation behaves very differently in the two regimes.

When inflation has settled at a low level, what we measure as increases in the overall price level mostly reflect price changes in specific sectors that are only loosely correlated with one another. Those price changes tend to leave but a temporary imprint on the inflation rate itself. Equally important, wages and prices, which are at the core of the inflation process, are only loosely linked to each other. As a result, inflation has certain self-stabilizing properties.

By contrast, a high-inflation regime has no such properties. The importance of the common component of price changes is much greater, wages and prices are more tightly linked, and inflation is especially sensitive to changes in salient prices, such as those of food and energy, as well as to fluctuations in the exchange rate.

There are several reasons why shifts from one regime to another are self-reinforcing. For one, inflation moves out of the zone of rational inattention—when businesses and individuals hardly notice it—into sharp focus. In addition, it becomes more representative: as prices increase, changes become more similar and synchronized, acting as a focal point—a kind of “coordinating device”—for business and individual decisions. This increases the likelihood of the wage-price spirals that lie at the heart of the inflation process.

Former Federal Reserve Board chairmen Paul A. Volcker and Alan Greenspan defined price stability as a condition in which inflation does not materially influence the behavior of economic agents. It is a condition that prevailed for decades. We took it almost for granted and, paradoxically, did not enjoy it enough. Now, central banks need to navigate back to this state. Failing to act forcefully might reduce the near-term costs, but only at the expense of higher ones down the road: the more entrenched inflation becomes, the harder it will be to vanquish.

This explains why central banks are responding forcefully to the current inflation episode. To be sure, they initially underestimated the strength and persistence of inflationary pressures. But they were quick to catch up in what has become the most synchronized and intense shift to monetary tightening since World War II, at least when measured in terms of nominal interest rates (real rates, which are adjusted for inflation, have moved less and remain relatively low).

At the time of writing, in mid-February 2023, central banks are raising interest rates more slowly. But the fight against inflation is far from over. And even as some key commodity prices have plateaued or started downward—providing essential relief and helping to drag inflation back—the last mile of the return to a low-inflation target may be the hardest to travel.

This could test the resilience of the financial system.

The good news is that banks are in much better shape than they were in the run-up to the Great Financial Crisis of 2008, thanks in no small measure to regulatory reforms. During the COVID crisis, banks were part of the solution, not the problem as they were in 2008. Still, there are no grounds for complacency. Because debt levels are high and assets richly valued, losses on loans and other exposures to firms and households could be substantial. Among the larger unknowns are the potential losses from banks’ direct and indirect exposures to nonbank financial intermediaries—notably various kinds of asset-management and trading firms.

By contrast, the nonbank financial intermediation sector is more vulnerable. Among recent examples are

  • The collapse of Archegos Capital Management in September 2021, which caused surprisingly large losses to banks
  • The so-called 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 (called gilts) as a budget crisis loomed
  • They could represent the proverbial canary in the coal mine.

The nonbank financial intermediary sector has grown massively since the Great Financial Crisis. The growth was in part an intended consequence of reforms in financial regulation that shifted risk from the banking sector to nonbank financial intermediaries, which rely less on borrowed funds (or, in financial parlance, are “less leveraged”). But the system is rife with hidden leverage and prone to funding stress. And risky behavior grew during the long phase of exceptionally low interest rates. What’s more, progress in developing an adequate regulatory framework for the sector has been disappointing. There is an urgent need to speed it up, focusing on the stability of the financial sector as a whole—a so-called macroprudential focus.

Possible problems with high private sector debt, such as that of households and firms, are of concern. But high public sector debt is, potentially, a bigger long-term issue. The sovereign, not the central bank, is the ultimate backstop of the financial system. It can tackle solvency problems, which the central bank cannot. A weak sovereign means a vulnerable financial system.

When inflation began to increase in 2021, global public sector debt, after a long-term climb, had reached a historical high, in line with the World War II peak. At the same time, in 2021, interest rates were at historical lows. With rates so low, the debt service burden had never felt so light. Governments and markets had expected that interest rates would remain low indefinitely, which provided a powerful incentive for governments to keep borrowing.

But interest rates did rise, and the higher rates could test the resilience of public finances. 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.

The picture that emerges from this analysis is sobering. After a long phase during which inflation lay dormant, central banks now face the once—but no longer—familiar challenge of preventing a shift from a low- to a high-inflation regime. But they are facing this challenge in what is a complicated and delicate financial landscape. By forcefully raising rates to prevent the transition to a high-inflation regime, central banks have shown their mettle. Yet, tougher tests may lie ahead.

CLAUDIO BORIO is head of the Monetary and Economic Department of the Bank for International Settlements.

Opinions expressed in articles and other materials are those of the authors; they do not necessarily reflect IMF policy.