August 02, 2022
Inflation is wreaking havoc on everything from grocery bills
to monthly mortgage payments.
Now at 8.1%, Canada’s sky-high inflation rate has become impossible to ignore. So have its potential ramifications. A new blog post from the International Monetary Fund (IMF) highlights the dramatic extent to which inflation is impacting monetary policy — and the potential urgency for more forceful tightening.
Titled Soaring Inflation Puts Central Banks on a Difficult Journey, authors Tobias Adrian, Christopher Erceg, and Fabio Natalucci highlight how central banks in major economies had expected to tighten monetary policy very gradually as recently as a few months back. With four rate increases since March, it’s safe to say it hasn’t exactly played out as such. In its more recent hike, Bank of Canada raised its benchmark interest rate by a full percentage point to 2.5% — the largest one-time increase in the bank’s rate since 1998.
“Inflation seemed to be driven by an unusual mix of supply shocks associated with the pandemic and later Russia’s invasion of Ukraine, and it was expected to decline rapidly once these pressures eased,” write the authors of the climate earlier this year. “Now, with inflation climbing to multi-decade highs and price pressures broadening to housing and other services, central banks recognize the need to move more urgently to avoid an unmooring of inflation expectations and damaging their credibility. Policymakers should heed the lessons of the past and be resolute to avoid potentially more painful and disruptive adjustments later.”
The blog post outlines how the actions and communications of the central bank have led to a notable rise in real (AKA inflation-adjusted) interest rates on government debt since the start of the event-filled year. The solution to attempt to push inflation back down to target levels has been to tighten policy.
“While short-term real rates are still negative, the real
rate forward curve in the United States — that is, the path of one-year-ahead
real interest rates one to 10 years out implied by market prices — has risen
across the curve to a range between 0.5 and 1%,” write the authors.
According to the IMF, this path is roughly consistent with a “neutral” real policy stance that allows output to expand around its potential rate. The authors point to the Fed’s mid-June Summary of Economic Projections, which suggested a real neutral rate of around 0.5%, and that policymakers saw a 1.7% output expansion both this year and next — a figure that’s “very close” to estimates of potential.
“The real rate forward curve in the euro area, proxied by German bunds, has also shifted up, though remains deeply negative,” reads the blog post. “That’s consistent with real rates converging only gradually to neutral.”
The IMF also highlights how rate hikes have resulted in a large rise in borrowing costs for consumers and businesses and contributed to sharp declines in equity prices globally.
“The modal view of both central banks and markets seems to
be that this tightening of financial conditions will be enough to push
inflation down to target levels relatively quickly,” reads the post. “To
illustrate, market-based measures of inflation expectations point to a return
of inflation to around 2% within the next two or three years for both the
United States and Germany. Central bank forecasts, such as the Fed’s latest
quarterly projections, point to a similar moderation in the rate of price
increases, as do surveys of economists and investors.”
The authors call this a reasonable baseline for a few reasons, pointing to a cooling of demand for energy and non-energy goods thanks to monetary tightening; the easing of supply-side pressures as the pandemic loosens its grip; and slower economic growth that should eventually push down service-sector inflation and restrain wage growth.
Despite this, they say the substantial risk inflation runs high.
“The magnitude of the inflation surge has been a surprise to central banks and markets, and there remains substantial uncertainty about the outlook for inflation,” reads the post. “It is possible that inflation comes down more quickly than central banks envision, especially if supply chain disruptions ease and global policy tightening results in fast declines in energy and goods prices.”
Even so, inflation risks appear strongly tilted to the
upside, say the authors. As such, there remains a “substantial risk that high
inflation becomes entrenched, and inflation expectations de-anchor.”
They point to how inflation rates for services are picking up from already elevated levels and are unlikely to come down in any hurry. These pressures may be reinforced by rapid nominal wage growth, say the authors.
In countries with strong labor markets, nominal wages could start rising rapidly, faster than what firms reasonably could absorb, with the associated increase in unit labor costs passed into prices,” reads the post. “Such ‘second round effects’ would translate into more persistent inflation and rising inflation expectations. Finally, a further intensification of geopolitical tensions that ignites a renewed surge in energy prices or compounds existing disruptions could also generate a longer period of high inflation.”
The authors say that — while reassuring — market-based
evidence on “average” inflation expectations (discussed above) may not happen
because markets appear to put significant odds on the possibility that
inflation may run well above central bank targets over the next few years.
“Specifically, markets signal a high probability of inflation rates of over 3%
persisting in coming years in the United States, euro area and the United
Kingdom,’ write the authors.
Persistently high inflation will come as no surprise to many. For the United States and Germany, household surveys show that people expect high inflation over the next year, highlights the post.
The authors conclude that more forceful tightening may be needed.
“The costs of bringing down inflation may prove to be markedly higher if upside risks materialize and high inflation becomes entrenched,” they write. “In that event, central banks will have to be more resolute and tighten more aggressively to cool the economy, and unemployment will likely have to rise significantly.”
Faster policy rate tightening may result in a further sharp decline in risk asset prices — affecting equities, credit, and emerging market assets, say the authors.
“The tightening in financial conditions may well be
disorderly, testing the resilience of the financial system and putting
especially large strains on emerging markets,” they write. “Public support for
tight monetary policy, now strong with inflation running at multi-decade highs,
may be undermined by mounting economic and employment costs. Even so, restoring
price stability is of paramount importance, and is a necessary condition for
sustained economic growth.”
The authors stress that a key lesson of the high inflation of the 1960s and 1970s was that moving too slowly to restrain growth entails a much more costly subsequent tightening to re-anchor inflation expectations and restore policy credibility. “It will be important for central banks to keep this experience firmly in their sights as they navigate the difficult road ahead,” they write.
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