Laying a robust macro-financial foundation for the future

After completing this reading, you should be able to:

• Explain why the sudden increase in inflation that reached a peak in 2022 following the Covid-19 pandemic did not result in a full-scale global recession.
• Identify and describe key factors that played a role in the process of disinflation around the world over the past year.
• Describe policy measures introduced and implemented by different central banks aimed at driving their economies toward meeting inflation targets.
• Discuss how monetary policy changes enacted by central banks to reduce inflation impacted equity prices, credit spreads, bond and equity volatilities, and bank lending.
• Describe monetary, fiscal, prudential, and structural policies that need to be adopted to promote (long-term) sustainable economic growth and low inflation.

Why the Sudden Increase in Inflation in 2022 Did Not Cause a Global Recession

There was a sharp increase in inflation following the COVID-19 pandemic, which peaked in 2022, but remarkably, it did not result in a full-scale global recession. The period following the pandemic saw a dramatic shift in the global macroeconomic landscape. Initially, economies experienced a strong rebound fueled by pent-up demand and fiscal stimulus. However, this recovery was accompanied by a surge in inflation, driven by supply chain disruptions, increased demand, and the war in Ukraine’s impact on commodity prices. Many feared this inflationary surge would trigger a global recession, as central banks began aggressively tightening monetary policy to combat rising prices. Surprisingly, a full-scale global recession was averted. The BIS report highlights several key factors that contributed to this resilience, which we will now explore:  

1. Resilient Labor Markets: Unlike previous tightening cycles, labor markets remained remarkably strong. Unemployment rates stayed close to pre-pandemic levels in many economies, even as monetary policy tightened significantly. This strength was partly due to the service-led recovery, which is more labor-intensive, and pandemic-related behavioral shifts in the labor market. This sustained employment supported household incomes and consumption, mitigating the impact of rising prices. For example, in many advanced economies, the unemployment rate barely budged despite the sharp tightening of monetary policy. This provided a crucial buffer for household spending.  
2. Smooth Monetary Policy Transmission: The transmission of monetary policy to the real economy was surprisingly smooth and non-disruptive. This was due, in part, to buoyant market sentiment, which kept risk spreads compressed and prevented major strains in the financial system. Furthermore, robust household and corporate balance sheets, characterized by a prevalence of fixed-rate loans and longer loan maturities, dampened the immediate impact of higher interest rates on borrowers. For instance, many homeowners had locked in low mortgage rates before the tightening cycle, shielding them from the immediate impact of rising rates. Similarly, many corporations had refinanced their debt at low rates, extending their maturities, which mitigated the immediate impact of rate rises on their borrowing costs.  
3. Resilient Emerging Market Economies (EMEs): Contrary to some earlier tightening cycles, EMEs demonstrated considerable resilience. This was attributed to stronger policy frameworks, including inflation targeting, greater exchange rate flexibility, and larger foreign exchange reserves. Improved prudential regulation and supervision had also bolstered the resilience of their banking systems. These factors helped anchor inflation expectations and reduce the pass-through of exchange rate fluctuations to domestic prices. For example, many EMEs had strengthened their central bank independence and adopted more credible inflation-targeting frameworks, which helped to maintain stability during the global tightening cycle.  
4. Global Disinflationary Forces (China): The slowdown in China’s economy and its subsequent export drive played a role in global disinflation. Falling prices for Chinese exports, combined with weaker domestic demand in China impacting commodity prices, exerted downward pressure on import prices in other economies. This effect is estimated to have significantly reduced import price inflation in major economies. For example, China’s export prices in sectors like clothing and manufacturing fell significantly, making these goods cheaper for importing countries.

Key Factors in the Process of Global Disinflation

Introduction

Over the past year, the world has witnessed significant disinflation, characterized by a reduction in inflation rates across various economies. This process was driven by a mixture of supply and demand factors, among other influences. Understanding these factors can provide insights into the macroeconomic dynamics that facilitated disinflation.

Commodity price retreat: A significant driver of the initial inflationary surge was the sharp increase in commodity prices, particularly energy and food. Conversely, the subsequent retreat of these prices has been a major contributor to disinflation. This decline stemmed from a confluence of factors: easing supply chain bottlenecks allowed for smoother production and distribution; increased production in some sectors, such as oil and gas, added to supply; and weakening global demand, partly due to monetary policy tightening, reduced pressure on commodity markets. For example, the price of crude oil, which significantly impacted inflation in 2022, has since declined substantially, reducing input costs for many industries and directly impacting consumer prices at the pump. Similarly, grain prices have fallen from their peaks following the initial shock of the war in Ukraine, easing food price inflation.

Supply chain normalization: The pandemic and subsequent geopolitical events caused severe disruptions to global supply chains, leading to shortages and higher prices. As these disruptions gradually eased, supply chains began to function more efficiently. This normalization has been reflected in various indicators, such as declining shipping costs and shorter delivery times. For instance, the Baltic Dry Index, a measure of shipping costs for dry bulk goods, has fallen significantly from its peak, indicating a reduction in shipping bottlenecks. This easing of supply chain pressures has allowed businesses to replenish inventories and meet demand more effectively, reducing upward pressure on prices.

Rotation of spending: During the pandemic, consumer spending shifted dramatically towards goods, placing immense strain on supply chains and contributing to goods price inflation. As economies reopened and restrictions eased, consumer spending began to rotate back towards services, such as travel, dining, and entertainment. This shift in demand helped to alleviate some of the pressure on goods production and distribution, contributing to disinflation in the goods sector. For example, as people resumed travel and dining out, demand for goods like home furnishings and electronics moderated, leading to price reductions or slower price growth in these categories.

Monetary policy tightening: Central banks globally responded to rising inflation with aggressive monetary policy tightening, primarily through increases in policy interest rates. These actions aimed to cool aggregate demand by making borrowing more expensive, thereby reducing spending and investment. While the full effects of monetary policy tightening often take time to materialize, they have undoubtedly played a role in curbing inflationary pressures. For instance, higher mortgage rates have cooled housing markets in many countries, reducing demand for new homes and related goods and services.

Anchored inflation expectations: The extent to which inflation expectations remain anchored is a critical determinant of the disinflation process. If individuals and businesses believe that central banks will successfully bring inflation back to target, they are less likely to engage in behaviors that perpetuate inflation, such as demanding higher wages or raising prices in anticipation of future inflation. Relatively stable long-term inflation expectations have been a positive factor in the recent disinflation process. For example, surveys of consumer and business inflation expectations have generally shown a gradual decline, suggesting that people believe inflation will eventually return to normal levels.

China’s disinflationary impact: China’s economic slowdown and its export strategy have contributed to global disinflation. Weaker domestic demand in China has reduced its demand for imports, impacting global commodity prices. Simultaneously, China’s export drive, with falling export prices in many sectors, has exerted downward pressure on import prices in other economies. This has acted as a disinflationary impulse for countries importing from China. For instance, lower prices for Chinese manufactured goods like textiles and electronics have reduced input costs for businesses in other countries and lowered prices for consumers.

Base effects: The high inflation rates observed in 2022 created a high base for year-over-year inflation calculations in 2023. As these high readings dropped out of the calculation, the reported inflation rate mechanically lowered, contributing to the disinflation trend. While not a fundamental change in underlying inflationary pressures, this base effect has contributed to the observed decline in headline inflation.

Key Takeaways:

• Increased supply, particularly in advanced economies, has been a significant driver of disinflation.
• The resolution of global supply chain disruptions has substantially decreased inflationary pressures.
• China’s economic dynamics have contributed to a global disinflationary trend.
• Monetary policy interventions have helped stabilize inflation expectations, supporting disinflation.

Policy Measures by Central Banks to Meet Inflation Targets

Central banks worldwide employed a range of policy measures to combat the surge in inflation following the COVID-19 pandemic. The primary objective was to guide inflation back to target levels, generally around 2% in many advanced economies. These measures focused on influencing both aggregate demand and supply-side factors.  

1. Monetary Policy Tightening

   This was the most prominent and synchronized action taken by central banks globally. It involved several key instruments:

   • Policy rate hikes: Central banks aggressively raised policy interest rates. This is the primary tool used to influence borrowing costs across the economy. By increasing the cost of borrowing for businesses and consumers, these hikes aimed to reduce spending and investment, thereby cooling aggregate demand and easing inflationary pressures. For example, the Federal Reserve in the United States, the European Central Bank (ECB), and the Bank of England all implemented substantial rate hikes.
   • Quantitative tightening (QT): In addition to raising rates, many central banks began reducing the size of their balance sheets (Quantitative Tightening). This involved selling off or allowing to mature the government bonds and other assets they had purchased during the period of quantitative easing (QE). QT further reduces liquidity in the financial system and puts upward pressure on longer-term interest rates, reinforcing the impact of policy rate hikes.  
   • Forward guidance: Central banks also communicated their intentions clearly to the markets through forward guidance. This included statements about the likely future path of interest rates and other policy measures. Clear communication aimed to manage expectations and enhance the effectiveness of policy actions. For example, the Federal Reserve emphasized its commitment to bringing inflation back to its 2% target, even if it meant some economic pain.  

2. Impact on Inflation

    These measures aimed to reduce inflation through several channels:

   • Demand reduction: Higher interest rates reduce borrowing and spending by businesses and consumers, leading to lower aggregate demand and easing price pressures.  
   • Anchoring inflation expectations: Central banks aimed to keep inflation expectations anchored by demonstrating a strong commitment to price stability. When people expect inflation to remain low and stable, this influences their wage-setting and price-setting behavior, which helps to prevent a self-fulfilling inflationary spiral.
   • Cooling commodity prices: Synchronized global tightening also contributed to cooling commodity prices, which had been a significant driver of inflation.

3. Divergence in Monetary Policy Stances

   While there was a high degree of synchronization in the initial phase of tightening, some divergence emerged as inflation started to recede.

   • Early easing in some economies: Some central banks, particularly in Latin America, which were among the first to tighten, began cutting rates as inflation came under control.  
   • Cautious approach in other advanced economies: Other central banks, such as the Federal Reserve, maintained a more cautious stance, emphasizing the need for greater confidence that inflation was converging to target before considering easing.  
   • Varied approaches in Asia: Central banks in Asia adopted varied approaches, partly reflecting lower inflation in the region and greater use of other stabilization instruments, such as foreign exchange intervention. The People’s Bank of China even eased monetary policy further due to weak domestic conditions. The Bank of Japan increased rates for the first time since 2007.

4. Coordination with Other Policies

   The report highlights the importance of coordinating monetary policy with other policies:

   • Fiscal consolidation: The report emphasizes the need for fiscal consolidation to support disinflation and restore debt sustainability. Expansionary fiscal policy could counteract the effects of monetary tightening.
   • Prudential policy: Vigilant prudential policy is crucial to ensuring the financial system’s resilience during periods of monetary tightening.  
   • Structural reforms: The report also calls for structural reforms to promote long-term sustainable growth and better income distribution. These reforms can enhance productivity and flexibility in the economy, which can help to keep inflation in check in the long run.

Impact of Monetary Policy Changes on Financial Markets

The aggressive monetary policy tightening implemented by central banks to combat inflation had significant repercussions across various segments of the financial markets and the banking sector.

1. Equity Prices:
   • Initial rally and subsequent adjustments: Initially, equity markets in most advanced economies (AEs) and emerging market economies (EMEs) rallied, driven by expectations of a “smooth landing” – a scenario where inflation would be brought under control without triggering a significant recession. This rally was fueled by improving earnings and the prospect of eventual policy rate cuts. However, this optimism was not uniform. China’s stock market struggled due to domestic real estate issues.
   • Impact of policy rate expectations: Market participants initially anticipated more aggressive monetary easing than central banks signaled. This divergence in expectations contributed to market volatility. As market sentiment aligned more closely with central bank assessments, particularly with renewed inflation concerns, equity market performance became more sensitive to incoming data and policy announcements.
   • Sectoral differences: Technology stocks, particularly those related to artificial intelligence (AI), experienced a particularly strong rally, with valuations reaching high levels relative to historical norms. This highlights how specific sectors can be more or less sensitive to overall monetary policy shifts depending on investor sentiment and future growth expectations.

2. Credit Spreads:

   • Narrowing spreads: Credit spreads, both for investment grade and high-yield bonds, generally narrowed during the period, reflecting the risk-on sentiment in the market and confidence in a smooth landing. Spreads fell below historical averages. This suggests that investors were less concerned about the creditworthiness of borrowers, despite the tightening monetary policy.
   • Subdued corporate bond issuance: Despite the narrowing spreads, corporate bond issuance remained subdued in both the euro area and the United States. This could be attributed to several factors, including uncertainty about the economic outlook and the higher cost of borrowing due to previous rate hikes, even if spreads had narrowed.

3. Bond and Equity Volatilities:

   • High bond volatility: A notable observation was the unusually high bond volatility, which often exceeded equity volatility. This is a rare occurrence. This high level of bond volatility reflected the significant uncertainty surrounding the future path of interest rates and the impact of monetary policy on the economy.
   • Uncertainty and market sentiment: The gap between bond and equity volatility highlighted the market’s sensitivity to monetary policy signals and the difficulty in predicting the timing and extent of future policy changes. This uncertainty contributed to overall market volatility.

4. Bank Lending:

   • Tightening lending standards: Monetary policy tightening led to a tightening of lending standards by banks. As the cost of funds increased and the economic outlook became more uncertain, banks became more cautious in their lending practices, requiring stricter conditions for borrowers to obtain loans.
   • Subdued loan demand: Higher borrowing costs and economic uncertainty also contributed to subdued loan demand from businesses and consumers. This is a natural consequence of monetary tightening, as higher interest rates make borrowing less attractive.
   • Weak credit growth: The combination of tighter lending standards and subdued loan demand resulted in weak credit growth. This is a key channel through which monetary policy affects the real economy, as reduced credit availability can dampen investment and consumption.
5. Overall Impact and Market Dynamics:
   • Financial conditions tightening: Despite the risk-on sentiment in some segments of the market, overall global financial conditions tightened during the period. This tightening was driven by the monetary policy actions of central banks and the market’s evolving expectations about future policy.
   • Market sensitivity to central bank communication: The market was highly sensitive to central bank communication and incoming economic data, constantly adjusting its expectations about the future path of interest rates. This resulted in periods of volatility and shifting market sentiment.
   • Convergence of market expectations: Over time, market expectations converged more closely with central bank assessments, particularly as renewed inflation concerns emerged. This suggests that central bank communication and actions eventually had a significant impact on shaping market expectations.

Policies for Sustainable Economic Growth and Low Inflation

The BIS report emphasizes that achieving sustainable economic growth with low inflation requires a comprehensive and coordinated policy approach encompassing monetary, fiscal, prudential, and structural policies. These policies must be designed to address immediate economic challenges and foster long-term stability and resilience.

1. Monetary Policy
   • Maintaining price stability: The primary long-term objective of monetary policy should be maintaining price stability, typically defined as low and stable inflation (e.g., around 2%). This provides a stable macroeconomic environment conducive to investment, saving, and economic growth.
   • Credibility and independence: Central banks need to maintain credibility in their commitment to price stability. This requires independence from political influence and clear communication of policy objectives and strategies.
   • Flexibility and responsiveness: While price stability is the long-term goal, monetary policy needs to be flexible enough to respond to economic shocks and fluctuations in the business cycle. This may involve adjusting interest rates or implementing other measures to stabilize output and employment in the short term while always keeping the long-term inflation target in sight.
   • Avoiding overreliance: The report cautions against overreliance on monetary policy for achieving all economic objectives. Monetary policy is primarily a tool for managing aggregate demand and influencing inflation. It cannot address structural issues or substitute for other necessary policies.

2. Fiscal Policy:

   • Fiscal consolidation: The report stresses the importance of fiscal consolidation, particularly in the context of high public debt levels. This involves reducing government spending and/or increasing revenues to improve the fiscal balance and ensure long-term debt sustainability.
   • Supporting disinflation: Fiscal consolidation supports disinflationary efforts by reducing aggregate demand and lessening pressure on prices. It also enhances the credibility of monetary policy by demonstrating a commitment to overall macroeconomic stability.
   • Structural fiscal policies: Beyond short-term consolidation, fiscal policy should also focus on structural measures that promote long-term growth. This includes investing in public infrastructure, education, and research and development, which can boost productivity and potential output.

3. Prudential Policy:

   • Strengthening financial system resilience: Prudential policies aim to ensure the stability and resilience of the financial system. This includes measures such as capital requirements for banks, liquidity regulations, and effective supervision.
   • Addressing macro-financial imbalances: Prudential policy should also address macro-financial imbalances, such as excessive credit growth or asset price bubbles, which can pose risks to financial stability and the broader economy.
   • Vigilance and proactive approach: The report emphasizes the need for ongoing vigilance and a proactive approach to prudential supervision, particularly in the face of evolving risks and vulnerabilities in the financial system.

4. Structural Policies:

   • Promoting sustainable growth: Structural policies focus on improving the long-term productive capacity of the economy. This includes measures that enhance competition, flexibility, and innovation.
   • Labor market reforms: Reforms to improve labor market flexibility can help to reduce unemployment and increase labor force participation.
   • Product market reforms: Reforms to reduce barriers to entry and increase competition in product markets can lead to lower prices, greater efficiency, and increased innovation.
   • Investment in human capital: Investments in education and training can improve the skills and productivity of the workforce, contributing to long-term economic growth.
   • Fostering innovation: Policies that support research and development, technological advancement, and entrepreneurship can drive innovation and boost productivity growth.
   • Improving income distribution: Structural policies should also aim to improve income distribution and reduce inequality. This can be achieved through measures such as progressive taxation, targeted social programs, and investments in education and skills development for disadvantaged groups.

5. Coordination and Long-Term Perspective:

   • Policy coordination: Effective coordination among monetary, fiscal, prudential, and structural policies is essential for achieving sustainable growth and low inflation. These policies should be mutually reinforcing and aligned towards common long-term objectives.
   • Long-term focus: Policymakers need to maintain a long-term perspective and avoid focusing solely on short-term considerations. This requires taking into account the long-term consequences of policy decisions and implementing policies that promote sustainable growth and stability over time.

In summary, the BIS report argues that a comprehensive and coordinated policy approach is crucial for achieving long-term sustainable economic growth with low inflation. This involves maintaining price stability through credible monetary policy, ensuring fiscal sustainability through fiscal consolidation and structural fiscal policies, strengthening financial system resilience through prudential policies, and promoting long-term productive capacity through structural reforms. Effective coordination among these policy areas and a long-term perspective are essential for achieving lasting economic prosperity.

Key Takeaways:

• Monetary policy should focus on maintaining price stability, setting a high bar for policy easing.
• Fiscal policies need to prioritize consolidation and efficiency in revenue mobilization.
• Prudential measures must stay vigilant, avoiding premature easing and focusing on financial system resilience.
• Structural reforms are essential to prepare the economy for future challenges, ensuring it remains competitive and resilient.

Question

According to the BIS Annual Economic Report, June 2024, which of the following is a key channel through which monetary policy tightening influences inflation?

A) By increasing government bond yields

B) By reducing the availability of credit and increasing borrowing costs

C) By implementing wage and price controls in key sectors

D) By encouraging banks to increase lending to small and medium-sized enterprises (SMEs)

Correct Answer: B

Monetary policy tightening, typically through raising policy interest rates, influences inflation primarily by:

• Increasing borrowing costs: Higher interest rates make loans more expensive for consumers and businesses, leading to reduced spending and investment.
• Reducing credit availability: Tighter monetary conditions can lead to stricter lending standards, further decreasing borrowing and spending.

This decrease in demand helps to alleviate upward pressure on prices, thereby contributing to lower inflation.

A is incorrect: While tightening can affect bond yields, the direct stimulation of private investment is not the primary channel through which it impacts inflation. Higher yields can even discourage some investment.

C is incorrect: Direct wage and price controls are not typical tools of monetary policy. These are usually considered fiscal or administrative measures.

D is incorrect: Tightening has the opposite effect, making it more difficult for SMEs to access credit.