The world’s top financial leaders are sending a loud and clear message: controlling excessive inflation will require an unprecedented effort and, most likely, a recession with job cuts and shockwaves across emerging economies.
However, it is still worthwhile to pay that price. The credibility of central banks, which have spent decades honing their ability to combat inflation, might be shattered if they lose this conflict.
According to Isabel Schnabel, a member of the European Central Bank’s board, they must immediately return inflation to its goal if they are to regain and maintain trust. The likelihood that the people would lose faith in government determination and capacity to maintain buying power increases the longer inflation remains high.
Additionally, banks must continue operating even if economic growth slows and job losses begin.
Schnabel said that they essentially have no choice but to stick with their current course of action even if they experience a recession. The impact on the economy would be substantially severe if inflation expectations were to deanchor.
In many of the largest economies in the world, inflation is close to double-digit territory, which is a level not seen in nearly fifty years. Peak is still months away, with the notable distinction of the United States.
The difficulty is that central banks generally seem to have only a limited amount of control.
One example is the supply shock caused by rising energy costs, which is a result of Russia’s conflict in Ukraine. Monetary policy has no impact on this supply shock.
Excessive government expenditure that is likewise unconstrained by a central bank makes the situation worse. According to research presented at Jackson Hole, the Federal Reserve will be unable to keep prices in check without the support of the government as 50% of U.S. inflation is fiscally motivated.
Finally, a new inflationary regime that will maintain price increases for a long time may be taking hold.
Supply restrictions may become more persistent as a result of deglobalization, alliance realignment as a result of Russia’s war, demographic changes, and more costly production in emerging markets.
Agustin Carstens, the director of the Bank of International Settlements, commented that the global economy appears to be on the verge of a historic shift as many of the supply curve tailwinds that have held inflation in check are expected to flip into headwinds.
If so, Carstens, who is in charge of a group known as the central bank of the world’s largest central banks, warned that the recent increase in inflationary forces may turn out to be more durable.
All of this suggests that interest rates will rise quickly in the next years, driven by the Fed while the ECB tries to catch up.
It’s crunch time for the Fed right now, according to Peter Blair Henry, a scholar and former dean of the Stern School of Business at New York University.
They will reduce inflation no matter what, even if it causes collateral damage in the developing world since the credibility of the past 40 years is on the line.
Since many emerging market nations borrow in dollars, higher Fed rates negatively impact them in several ways.
It raises concerns about debt sustainability and drives up borrowing costs. Additionally, it transfers liquidity to American markets, driving up risk premiums for emerging nations and making borrowing much more challenging.
The dollar will continue to strengthen versus the majority of other currencies, increasing imported inflation in emerging nations.
Larger nations like China and India seem to be doing fine on their own, but a large number of smaller nations, from Turkey to Argentina, are unquestionably struggling. IMF senior economist Pierre-Olivier Gourinchas, said that several countries, particularly those with frontier economies and low-income levels, have experienced an increase in their spreads to what they refer to as distress or near distress levels, or 700-basis points (bps) to 1000-basis points.