Crisis and Monetary Policy

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Crisis and Monetary Policy

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Bibliographic details

• Authors: GITA GOPINATH
• Published: March 1, 2023

Overview and context

• Title: Crisis and Monetary Policy
• Author: GITA GOPINATH
• Publication: F&D Magazine
• Date: March 2023
• Author note: GITA GOPINATH served as IMF First Deputy Managing Director from January 21, 2022, until August 2025.
• Read time indicator: Less than a minute(0 words) Read
• Core premise: The global inflation surge that abruptly ended decades of moderating price gains came at a unique confluence of crises: the global pandemic and Russia’s invasion of Ukraine. These events have bred new challenges for global central banks.

Accounting for the inflation surge — empirical findings

• Precrisis models and evidence:
  • Empirical evidence suggested that inflation rose by only a small amount when unemployment declined, consistent with a very flat Phillips curve.
  • Pre-pandemic experience: inflation remained tepid even as monetary stimulus pushed unemployment to very low levels.
  • Most inflation forecasts based on these models, including those at the IMF, significantly underpredicted inflation during the pandemic-era surge.
• Explanations for forecast failure:
  • Misunderstanding of the Phillips curve and the supply side of the economy likely contributed to forecast errors.
  • “Speed effects”: rapid employment recovery may have played a significant role in driving inflation.
  • 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 importance of capacity limits at the sectoral as well as aggregate level.

Lessons for monetary policy — analytical implications

• Model improvements needed:
  • Need for better aggregate supply models that reflect pandemic lessons.
  • Further develop sectoral models differentiating goods and services that incorporate sectoral capacity constraints to account for speed effects and nonlinearities.
• Reconsideration of pre-pandemic policy prescriptions:
  • Prior prescription: unemployment well below its natural rate was acceptable, even desirable, given low inflation outcomes pre-pandemic.
  • New insight: inflation risks from running the economy hot may be much greater than previously thought.
• Measurement challenges:
  • The pandemic highlighted difficulties in measuring economic slack; mismeasurement is problematic if the Phillips curve is nonlinear when unemployment falls below a highly uncertain natural rate.
  • Risk of inadvertently pushing unemployment below an overly optimistic estimate of the natural rate, potentially fueling an inflationary surge similar to the Great Inflation of the 1970s.
  • Running the economy hot increases likelihood that key sectors will hit capacity constraints, generating broad-based inflationary pressures.
• Response to supply shocks:
  • Pre-pandemic view: central banks could “look through” temporary supply shocks and react only to second-round effects.
  • Pandemic experience: supply shocks can have broad, persistent inflationary effects, spreading through supply chains, to wages, or affecting inflation expectations with surprising speed.
  • Implication: central banks should react more forcefully under certain conditions—initial conditions matter. Looking through a shock may be problematic if inflation is already high.
  • Conditions necessitating stronger responses: high initial inflation, a strong economy where producers can pass on rising costs, workers unwilling to accept real wage declines, or when shocks are broad-based rather than sector-concentrated.

Risk of persistence and macro scenarios

• De-anchoring expectations:
  • Key risk: high inflation de-anchors inflation expectations, complicating monetary policy trade-offs because currency depreciations and supply shocks would have more persistent inflationary effects.
  • Bigger interest rate hikes to contain inflation would cause larger output contractions.
  • Significant and front-loaded tightening by several central banks over the past year have helped attenuate de-anchoring risks.
• Supply shock entrenchment and trade fragmentation:
  • If countries raise trade barriers to reduce supply-chain risk, supply shocks could become more entrenched, increasing supply shock volatility and making stabilization harder.
  • 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:
  • The pandemic and war could affect the equilibrium real interest rate via impacts on inequality, demographics, productivity, demand for safe assets, and public investment and debt.
  • Examples: pandemic and war may further depress the equilibrium rate by increasing demand for safe assets and raising inequality.
  • Overall assessment: 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 scenario: a persistent shift to deficit spending, or a sizable catch-up in climate investment, could materially boost the equilibrium rate.

Policy implications and recommendations

• Central bank strategy:
  • Managing risks requires accounting for both inflation that’s too low and inflation that’s too high, and recognizing stronger tensions between price stability and employment/growth.
  • Revisit robustness of strategies such as running the economy hot and routinely “looking through” supply shocks.
  • 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.
  • Restoring price stability is a prerequisite for sustained economic growth.
• Complementary policies beyond central banking:
  • 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.

Source: IMF F&D Magazine — "Crisis and Monetary Policy" by GITA GOPINATH, March 2023.

Content in this bundle

• F&D March 2023: Crisis & Monetary Policy
  • F&D March 2023: Crisis & Monetary Policy (Markdown version)
  • F&D March 2023: Crisis & Monetary Policy (PDF)