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In high-income countries, consumer price inflation is at levels not seen in four decades. Since inflation is no longer low, neither are interest rates. The era of “low for long” is over, at least for now. So why did this happen? Will this be a lasting change? What should be the policy response?
Over the past two decades, the Bank for International Settlements has offered a different perspective than most other international organizations and major central banks. In particular, she highlighted the dangers of an ultra-accommodative monetary policy, high debt and financial fragility. I agree with some parts of this analysis and disagree with others. But her Cassandra-like position has always been worth considering. This time too, it’s Annual economic report provides valuable analysis of the macroeconomic environment.
The report sums up recent experience as “high inflation, surprising resilience in economic activity and early signs of serious strains in the financial system.” He notes the widely held view that inflation will melt away. In contrast, he points out that the proportion of consumer basket items whose prices increase annually by more than 5% has reached more than 60% in high-income countries. He also notes that real wages fell significantly during this episode of inflation. “It would be unreasonable to expect workers not to try to catch up, especially as labor markets remain very tight,” he says. Workers could recoup some of these losses, without sustaining inflation, provided profits are squeezed. In today’s resilient economies, however, a distributive struggle seems much more likely.
Financial fragility makes policy responses even more difficult to calibrate. According to the Institute of International Finance, the ratio of global gross debt to GDP was 17% higher at the start of 2023 than it was just before the Lehman collapse in 2008, despite post-Covid declines (helped by inflation). Already rising interest rates and bank runs have caused disruption. Further problems are likely as losses mount at institutions most exposed to property, interest rate and maturity risks. Also over time, households are likely to suffer from higher borrowing costs. Banks with stock prices below book value will struggle to raise more capital. The situation of non-banking financial institutions is even less transparent.
![Column chart of monetary tightening episodes (% of central banks) showing Current monetary tightening is brief, so far, but widespread](https://www.ft.com/__origami/service/image/v2/images/raw/https%3A%2F%2Fd6c748xw2pzm8.cloudfront.net%2Fprod%2F4e34e3c0-1993-11ee-960e-a3b69ad73c46-standard.png?dpr=1&fit=scale-down&quality=highest&source=next&width=700)
Such a combination of inflationary pressures and financial fragility did not exist in the 1970s. Partly for this reason, “the last mile” of the disinflationary journey may be the most difficult, the BIS suggests. This is plausible, not only for economic reasons, but also for political reasons. Naturally, the BRI does not add populism to its list of worries. But it should be on it.
So how did we get here? We all know about the post-Covid supply shocks and the war in Ukraine. But, notes the BIS, “the extraordinary monetary and fiscal stimulus deployed during the pandemic, although justified at the time as an insurance policy, appears too big, too broad and too long-lasting”. I would agree on that. Meanwhile, financial fragility has clearly built up over the long period of low interest rates. Where I disagree with the BIS is on whether “weak for a long time” could have been avoided. The Bank of Japan tried in the early 1990s and the European Central Bank in 2011. Both failed.
![Column chart of global debt as % of GDP showing indebtedness has risen to even higher levels since the global financial crisis](https://www.ft.com/__origami/service/image/v2/images/raw/https%3A%2F%2Fd6c748xw2pzm8.cloudfront.net%2Fprod%2Fb731cfd0-19a4-11ee-bb0a-d5e3e166da13-standard.png?dpr=1&fit=scale-down&quality=highest&source=next&width=700)
Will what we are currently experiencing prove a lasting change in the monetary environment or only temporary? We do not know. It depends on the extent to which high inflation was only the product of supply shocks. It also depends on whether societies long unaccustomed to inflation decide that it is too painful to roll it back, as happened in so many countries in the 1970s. It also depends on the extent to which the fragmentation of the global economy has permanently lowered supply elasticities. It depends in particular whether the era of ultra-low real interest rates is over. If not, it could indeed be a blip. If so, significant stress lies ahead, as higher real interest rates make current debt levels difficult to sustain.
![Line chart of average residual maturity of government securities (years) showing that lengthening the maturity of government debt creates risk for creditors](https://www.ft.com/__origami/service/image/v2/images/raw/https%3A%2F%2Fd6c748xw2pzm8.cloudfront.net%2Fprod%2F2f5b88d0-199a-11ee-a998-b58a2ad6d79e-standard.png?dpr=1&fit=scale-down&quality=highest&source=next&width=700)
Finally, what to do? The BRI believes in the religion of the old days. He argues that we have placed too much faith in fiscal and monetary policies and too little in structural policies. Partly for this reason, we’ve pushed our economies out of what she calls “the region of stability,” in which expectations (particularly for inflation) are largely stabilizing on their own. His distinction between how people behave in low inflation and high inflation environments is valuable. We now risk moving permanently from one to the other. The evolution of the next few years will be decisive. This that is why central banks have to be pretty brave.
However, I am not convinced by all the tenets of this faith. The BIS argues, for example, that policymakers should have been more relaxed in the face of still-low inflation. But it would have greatly increased the chances that monetary policy would be powerless in the event of a severe recession. He also argues that macroeconomic stabilization is not so important. But prolonged recessions and high inflation are at least as intolerable. Moreover, a stable macroeconomic environment is favorable for growth, to say the least, as it greatly facilitates business planning.
Above all, I am still not convinced that the overriding objective of monetary policy should be financial stability. How can it be argued that economies must be kept permanently weak in order to prevent the financial sector from blowing them up? If that is the danger, let’s target it directly. We should start by eliminating tax deductibility of interest, increasing penalties for people who run financial businesses, and making resolution of financial institution failures work.
Yet the BRI still raises big issues. It’s invaluable, even if you disagree.
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