European Central Bank board member Isabel Schnabel attends a dinner program at Grand Teton National Park where financial leaders from around the world are gathering for the Jackson Hole Economic Symposium outside Jackson, Wyo., on Aug. 25.JIM URQUHART/Reuters
Central banks are entering an era of heightened volatility where the global economy will be buffeted by supply shocks and where controlling inflation may require painful trade-offs between stabilizing prices and supporting economic growth, top policy makers have warned.
Speaking at an exclusive gathering of the world’s top central bankers in Jackson Hole, Wyo., over the weekend, numerous officials and economists warned of tough times ahead for monetary policy.
The worst inflation crisis in a generation has put central banks around the world on a back foot. After waiting too long to start tightening monetary policy, central banks are now having to raise interest rates aggressively, even at the risk of causing a recession, to prevent inflation from spiralling out of control.
Looking further ahead, officials at Jackson Hole warned that many of the forces that helped keep inflation low and stable in recent decades have begun to recede.
“The global economy seems to be on the cusp of a historic change as many of the aggregate supply tailwinds that have kept a lid on inflation look set to turn into headwinds,” Agustin Carstens, general manager of the Bank for International Settlements, said in a speech to the symposium. “If so, the recent pickup in inflationary pressures may prove to be more persistent.”
Since the 1980s, trends in global trade, demographics, energy production and technology have generally put downward pressure on prices and wages. That helped keep inflation in check and gave central banks flexibility to respond to economic downturns by loosening monetary policy without worrying about runaway consumer prices.
Now rising protectionism and supply chain disruptions caused by the COVID-19 pandemic and the war in Ukraine are slowing, even reversing, the process of globalization.
“The pandemic and the war are likely to add to instability in the years to come,” Isabel Schnabel, board member of the European Central Bank, said during a panel discussion.
“They challenge two of the fundamental stabilizing forces that have contributed to the decline in volatility during the Great Moderation: globalization and an elastic energy supply,” she said, referring to the period of low inflation between the mid-1980s and the 2008 financial crisis.
There are also structural changes related to an aging population and the transition toward a low-carbon economy. Retiring baby boomers are shrinking the size of the labour force – a dynamic that could put upward pressure on wages over time. Meanwhile, the widespread shift toward more renewable forms of energy could push up energy prices in the coming years, at least during the period of transition.
These tectonic shifts mean that fluctuations in inflation in the coming years could increasingly be driven by supply-side shocks, rather than changes in demand. That has major implications for monetary policy, which for decades had been able to stabilize both inflation and economic output – a fact economists called the “divine coincidence” – but now faces trade-offs between the two.
Monetary policy is designed to control demand in the economy, speeding up or slowing down inflation by adjusting interest rates to make it more or less appealing to borrow and spend money. Central banks are much less well equipped to deal with inflation that is caused by supply-side shocks, such as commodity price spikes or factory shutdowns caused by pandemic-related measures.
The prospect of more supply-side disruptions in the coming years requires a “reset to macroeconomic policy-making,” Mr. Carstens said.
“In this environment, central banks cannot hope to smooth out all economic air pockets, and must instead focus first and foremost on keeping inflation low and stable,” he said.
“Fiscal policy should also be aware of tighter limits on what demand management policies can deliver. In a world of unforgiving supply, what fiscal stimulus adds to demand may need to be taken away by monetary policy tightening.”
Jean Boivin, former deputy governor of the Bank of Canada and now head of BlackRock Investment Institute, said the commentary coming from Jackson Hole shows that central bankers are finally coming around to the new macroeconomic reality. In the past few decades, most changes in inflation have been driven by changes in demand, Dr. Boivin said in an interview. That’s no longer the case.
“In the environment we are now in, the fluctuations are not really coming from demand being too high or too low,” he said. “It’s really production constraints that are limiting the ability to continue to grow or to expand. And interest rates don’t really address the root cause; they’re not the cure for the disease.”
Central banks can always get inflation under control if they’re willing to raise interest rates high enough, Dr. Boivin said. But getting supply-side inflation under control typically entails causing more economic pain.
“You need to destroy the interest-rate-sensitive part of the economy to cool off inflation, which is not the culprit for the inflation in the first place. And so that’s a sharper trade-off,” he said.
In the current fight with inflation, central bankers seem willing to cause a considerable amount of economic damage in order to get prices back under control and prevent people from expecting permanently higher inflation. In his keynote speech at Jackson Hole on Friday, U.S. Federal Reserve chair Jerome Powell pushed back against market expectations that the Fed may start slowing interest-rate hikes and even begin cutting rates next year, as the U.S. economy starts to slow.
“Reducing inflation is likely to require a sustained period of below-trend growth,” Mr. Powell said, in comments that sent global stock markets tumbling. “While higher interest rates, slower growth and softer labour-market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.”
Bank of Canada governor Tiff Macklem, who attended the Jackson Hole symposium but did not speak on any panels, has taken an equally hawkish tone on inflation in recent months. The central bank raised interest rates at four consecutive rate decisions, including a full percentage-point rate hike in July.
At the news conference following last month’s rate decision, Mr. Macklem said longer-term structural forces may put upward pressure on inflation over time.
“These things are relatively slow moving, and we will see,” he said. “But the one thing I would stress right now is, we have some ability to influence what that future looks like, and the best thing we could do today to make that future better would be to keep inflation expectations well-anchored.”
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