Inflation remains high despite policy tightening
The Bank for International Settlements (BIS), the central bank of central banks, has warned that inflation remains a serious threat to the global economy, despite the most intensive monetary policy tightening in recent memory. In its flagship economic report, the BIS said that inflation has started to subside from multi-decade highs almost everywhere, but the work of central banks is far from done.
The BIS noted that central banks have raised policy interest rates aggressively to cool activity and bring inflation back to target. However, it cautioned that the last leg of the journey to restore price stability will be the hardest, as central banks face a unique mix of high inflation and financial stability risks.
The BIS said that inflation has been driven by an unusual combination of supply shocks associated with the pandemic and later Russia’s invasion of Ukraine, as well as strong demand fueled by fiscal stimulus and pent-up savings. It added that these factors have created significant uncertainty about the persistence and transmission of inflation.
The BIS also pointed out that inflation expectations have risen sharply in many countries, especially among households and financial markets. It said that this poses a risk of self-fulfilling inflation dynamics, where higher expected inflation leads to higher actual inflation and vice versa.
Central banks need to maintain trust and credibility
The BIS stressed that central banks need to maintain trust and credibility in their institutions, as they are the ultimate guardians of price stability. It said that central banks should communicate clearly and consistently about their policy objectives and actions, and explain how they balance the trade-offs between inflation and financial stability.
The BIS also urged central banks to be prepared for possible adverse scenarios, such as a further rise in inflation or a sudden reversal of financial conditions. It said that central banks should have adequate policy tools and frameworks to deal with such shocks, and coordinate with other authorities to ensure financial system resilience.
The BIS also highlighted the importance of international cooperation among central banks, especially in light of the spillovers and spillbacks of monetary policy across borders. It said that central banks should take into account the global implications of their actions, and foster dialogue and information sharing among themselves.
Central banks face trade-offs between inflation and financial stability
The BIS acknowledged that central banks face difficult trade-offs between inflation and financial stability, as they tighten monetary policy against a backdrop of high debt and asset prices. It said that higher interest rates could trigger financial stress and amplify economic downturns, especially in emerging market economies that are more vulnerable to capital outflows and currency depreciation.
The BIS also warned that low interest rates for long have encouraged excessive risk-taking in financial markets, leading to stretched valuations and increased leverage. It said that these imbalances could unwind abruptly if investors reassess their risk appetite or expectations about future returns.
The BIS suggested that central banks should use macroprudential policies, such as capital buffers and loan-to-value ratios, to complement monetary policy and address financial stability risks. It also recommended that fiscal policy should play a more active role in supporting economic activity and reducing inequality, while ensuring long-term debt sustainability.
