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The global economy is at a critical juncture that could weigh on prosperity for years to come. For the first time in decades, we are facing a combination of hyperinflation and fiscal malaise. To prevent these problems from taking root, it is time for a reality check on what current policy systems can and cannot achieve.
Global inflation came down from its peak as supply chains normalized, commodity prices fell, and central banks began tightening their strongest and most coordinated monetary policy in years. A recent Bank for International Settlements annual economic report noted that even in episodes less severe than those following a pandemic, history shows that inflation typically takes a year to return to its previous level.
Against this backdrop, optimism is building in some quarters that the global economy will achieve a soft, or soft, landing. But we must be prepared to deal with significant risks that cloud the outlook.
A risk is that high inflation may persist. New price pressures may emerge. In many countries, households’ purchasing power has declined as wages have not kept pace with inflation. With tight labor markets, workers may seek to rebalance. Companies find it easier to raise prices, and higher costs can be passed on to consumers, creating a vicious cycle. Once it sets in, it’s hard to stop.
Meanwhile, there are risks to financial stability. Debt and asset prices are higher than past interest rate hikes. So far, there have been buffers from pandemic-era savings and longer credit terms. But these buffers are diminishing. As they run out, growth will be slower than currently expected.
The resulting financial distress may come through loan losses. Weak banks risk losing their footing. Historically, bank stress often goes hand in hand with higher interest rates. High debt, high asset prices and high inflation increase the risks. The current episode ticks all the boxes. Even though banks are stronger than ever, there are pockets of vulnerability, especially because the provisions to strengthen banks are not applied to smaller banks. As recent experience has shown, even small firms can trigger systemic declines in confidence.
Non-bank financial institutions will also be challenged. These types of investment firms have grown rapidly since the Great Financial Crisis. They are full of hidden leverage and liquidity mismatches. Business models that worked in the era of low-long rates will face severe tests in the high-long period.
Shaky government coffers further cloud the picture. Financial instability, if severe enough, forces governments to enter backstop markets. And it provides growth success that weakens financial returns. This will increase the already high level of public debt. In turn, any doubts about the government’s ability to pay its bills increase fiscal instability.
How should policymakers respond to these challenges? The task of central banks is clear: they must restore price stability. A transition to permanent high inflation will have huge costs, especially for the most vulnerable in our communities.
Additional measures should be taken to ensure the safety and stability of financial institutions and financial systems to give central banks more room to fight inflation. Where there are gaps, new regulations may be required. As central banks and governments work together, macroprudential policies should be kept tight, as this could lead to higher rates at banks. And tougher banking supervision could fix some of the wrongdoing that came to light in recent bank failures. We urge policy makers to implement Basel III now without further delay.
Fiscal policy should be coordinated. This will also help in the fight against inflation and improve financial stability. This will provide badly needed buffers that can be used against future downturns.
Above all, policy should take a long-term view. Monetary and fiscal policies bear much of the burden of sustaining economic growth. As a result, they have rigorously tested the boundaries of what we call the area of stability, the combination of monetary and fiscal policy that fosters sustainable economic and financial stability and mitigates the inevitable tensions between them. History shows that exceeding these limits can trigger hyperinflation, economic collapse, and banking, currency, or sovereign crises.
Policymakers need to be realistic about what they can achieve. High inflation and financial instability did not emerge by accident. They are the result of a long journey, an overly ambitious view of the ability of monetary policy to hit the small inflation target and reflect a general belief that macroeconomic policy will support growth indefinitely without fueling inflation.
Minds must change. They must recognize the pitfalls of repetitive emergency action, which spurs output in a downturn but fails to rebuild buffers when growth resumes. To drive long-term economic prosperity, governments must revive long-neglected structural reforms.
Without fact-checking, the public can lose the trust it should have in policy-making. Only price and financial stability can ensure broad economic prosperity in the long run. Jakarta Post/Asia News Network
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Augustin Carstens is the General Manager of the Bank for International Settlements.
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The Philippine Daily Inquirer is a member of the Asia News Network, an alliance of 22 media titles in the region.
Read: Controlling Inflation