Fifteen Eighty Four

After the extensive support to monetary and financial sectors in the aftermath of the global financial crisis and then during the Covid-19 pandemic, central bankers are now faced with the difficult task of engineering a controlled re-entry to the normal cycle of demand management. As we can all begin to see, the two-year interruption to the normal pattern of world trade and growth may finally be coming to an end this Spring as we seemed to have shrugged off the most dangerous variants of COVID-19. The stimulus from monetary and fiscal policies that limited the impact of lockdowns on the global economy and supported the strong recovery from the sudden stop of the pandemic will have to be re-oriented. The immediate priority is to address burgeoning levels of public debt and substantially negative short term real rates. It does look more than a little like the global level of public debt traces out a demand curve relative to its price – put simply governments have gobbled up ever more debt as it has become progressively cheaper to issue. And each country will now face a different set of constraints and feasible set of policy choices to achieve adjustment and an enduring financial stability.

The main policy concern is that of price stability and that is one I return to time and time again in The Money Minders. We expect OECD inflation to go significantly above 5% this year, which will be the highest since 1999. It is, of course, widely understood that much of the inflationary impulse seems related to a sharp rise in energy prices and from supply chain tensions that are pushing up transport costs. As such they reflect the costs of getting back to normal and placing factors in the right place to meet demand and, as such, might be thought of as a temporary tax on trade. But the size of the shocks and the extent to which they are likely to spread to other goods and services over time means that they expose the fallacy of continuing with ultra-accommodative monetary policies. It is more probable than not that inflation will overshoot orthodox notions of price stability and the problem faced is not so much of whether to tighten policy but how to do so when presented with an asset price bubble and financial markets that do not seem to like taking much risk.

The Federal Reserve, for example, must now seek to regain control over inflation with a rapid (by recent historical standards) tightening in monetary conditions. The Bank of England has just embarked on a clear tightening cycle and we expect Norges Bank, the Bank of Canada and the Bank of New Zealand to follow suit. Though it is not expected that the Bank of Japan or ECB will do anything like as much and this may promote some exchange rate volatility. Ending the dozen year bull market in fixed income markets will be no simple task and we can expect tantrums. Advanced economies though will tend to continue to have recourse to borrow from capital markets to help smooth adjustment and deal with any hiccups along the way. To help support the use of such an option, some further thought needs to be given to the flexibility of fiscal frameworks and the work of fiscal councils.

Many emerging markets are not quite so lucky. Those with high external debt and anticipated to have low growth, for example South Africa, Brazil and Mexico, will remain exposed to financial market stress, particularly should investor risk sentiment deteriorate because of increased inflation pressures in advanced economies. This problem will be amplified for many emerging economies with the commencement of tighter monetary and financial conditions in advanced economies, and with the impending retreat from the central bank holdings of large stocks of asset purchases. It is under circumstances of monetary policy tightening in the past that some emerging countries have been tipped into a full-blown crisis with the experiences of both Argentina and Russia prominent in the memory. We draw particular attention to the current issues facing Turkey at present where shocks do not seem to be being met with orthodox responses and many of the conditions for a crisis seem to be amassing.

In many ways the world economy is now heading into very dangerous territory. The initial set of responses to the pandemic were well formulated but also rather obvious. The lockdowns introduced to slow the progress of COVID-19 were public health measures and so the same public needed monetary and fiscal support to limit the economic damage. But that could never be open ended and has left both a public debt hangover and a sequence of monetary impulses that have not yet been absorbed by higher nominal GDP. It will be firm aim of monetary and fiscal authorities to ensure that as much absorption as possible finds it way into real output rather than an undermining of the nominal anchor. It is therefore critical that commitments to price stability are both honoured in word and in practice.