At its last week’s Annual Meetings, the IMF has declared an (almost) victory over inflation. “Almost” is because the services price inflation is still elevated. But the headline inflation is expected to get within the target for most advanced economies in 2025. On the downside, the risks are elevated: due to uncertainties related to the climate and geopolitical instability, the inflation shocks are likely to be more frequent in the future.
The IMF gives big credit to central banks’ tight monetary policy in bringing the inflation down. I tend to disagree, as the recent bout of inflation was driven mainly by the supply shock, especially in Europe, and has come down primarily due to the alleviation of supply pressures and in some cases thanks to effective government policies (for example in Spain).
This difference in diagnosis is consequential: the IMF conclusion is that the next time a supply shock happens, central banks need to decisively tighten the policy. This is a problematic proposition for a range of reasons. First, this may cause a recession. This time the recession did not happen, but it is always a risk in case of tight monetary policy. Second, at a time when massive investments are needed in green transition, high interest rates are counterproductive. Third, interest rate changes have an impact on income and wealth redistribution. According to ECB analysis, changes in interest rates affect strongly the middle class who tend to have mortgages. Also, regional economic inequality is exacerbated due to higher interest rates. Yet another ECB analysis shows that an increase in interest rates in response to energy price shock exacerbates recessionary effects and dampens consumption by poorer households. Fourth, high interest rates affect disproportionately low-income countries, and many of them now are in dire financial condition due to the 2022-23 hike in interest rates in the developed world.
As the supply-side shocks are going to become more frequent, the central banks will soon reach limits to how much and how often they can increase interest rates. There should be a rethink on the policy toolbox to deal with inflation, especially if it comes from supply-side shocks. In particular, fiscal and regulatory policies should play a bigger role, and the central banks should engage in closer coordination with the governments on their inflation response. The strategy review that the ECB is starting now and is expected to complete in 2025 is an opportunity to make the necessary policy adjustments.
FEPS, the organisation where I work, is actively engaged on this topic and has organized several events (in May 2023 and January 2024), published a policy brief and is finalizing a bigger policy study on the toolbox to deal with profits-led inflation.
Picture credit: IMF
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