Keeping inflation under control will be a global challenge

An inflationary negative supply shock poses a dilemma for central bankers. They should stabilize inflation expectations, so they need to normalize monetary policy quickly, even if it will lead to further downturns and possibly recessions. But since they also care about growth, they need to move slowly, even if it risks lowering expectations and setting off a wage-price spiral.

Fiscal policy makers also face a difficult choice. Given supply shocks, increasing transfers or reducing taxes is not optimal, as it prevents private demand from collapsing in response to a decrease in supply. Thankfully, EU governments spending more on defense and decarbonisation can count these forms of stimulus as investments that will ease supply constraints over time. Still, any additional spending would add to the debt on top of the extreme response to the pandemic.

As Covid subsides, governments have gradually introduced fiscal consolidation and central banks have begun policy normalization to rein in price inflation, the Ukraine war has introduced new complications.

Fiscal-monetary coordination defined the pandemic response. But now, as central banks are stuck with their new tough stance, fiscal officials have implemented easier policies (such as fuel-tax relief) to cushion the energy shock. Coordination seems to have given way to the division of labour, with central banks addressing inflation and legislatures to deal with issues of growth and supply.

In theory, most governments have three economic objectives: to support economic activity, ensure price stability, and keep long-term interest rates or sovereign spreads under control through frequent monetization of public debt. An additional goal is geopolitical: Putin’s invasion must be met with a response that both punishes Russia and deters others from considering similar acts of aggression. The tools in use are monetary policy, fiscal policy, and regulation. Until recently, reinvestment policies and flight-to-safety capital flows kept long-term interest rates low, keeping downward pressure on ten-year Treasury and German bond yields.

Because of this confluence of factors, the system has reached a temporary equilibrium, with each of the three objectives being partially addressed. But recent market signals, such as a significant increase in long-term rates and intra-euro spreads, suggest that this policy mix will become inadequate, creating new inequalities.

Additional fiscal stimulus and sanctions on Russia could fuel inflation, partially defeating monetary policy efforts. In addition, central banks’ campaign to control inflation through higher policy rates would be inconsistent with accommodative balance-sheet policies, and could result in longer-term interest rates and sovereign spreads. Central banks will have to grapple with the inconsistent objective of controlling inflation while keeping long-term rates low. And at all times, governments will continue to fuel inflationary pressures with fiscal stimulus and persistent sanctions.

Over time, tighter monetary policies can lead to a slowdown in growth or an outright slowdown. But there is another risk that monetary policy will be hampered by the threat of a debt trap. With historically high levels of private and public debt as a share of GDP, central bankers can make policy generalizations even before they risk a financial crash in the debt and equity markets.

At that point, governments, under pressure from disgruntled citizens, may be tempted to come to the rescue with price and wage limits and administrative controls to control inflation. These measures have proved unsuccessful in the past, at least not in the stalemate of the 1970s, and there is no reason to think this time will be any different. If anything, some governments will make matters worse by reintroducing the automatic indexing mechanism for wages and pensions.

In such a scenario, all policy makers will realize the limits of their own means. Central banks will see that their ability to control inflation is limited by the need to continue to monetize public and private debt. And governments will see that their ability to maintain sanctions on Russia is constrained by negative effects on their own economies (both in terms of overall activity and inflation).

There are two possible endgames. Policymakers may drop one of their objectives, leading to higher inflation, lower growth, higher long-term interest rates, or softer restrictions, as well as perhaps lower equity indices. Alternatively, policymakers may settle for only partially achieving each goal, leading to sub-optimal macro outcomes of higher inflation, lower growth, higher long-term rates and softer restrictions – with lower equity indices. And then the emerging fiat currencies. Either way, families will feel the pinch, which will have further political ramifications. ©2022/Project Syndicate

Nouriel Roubini and Brunello Rosa, professor emeritus of economics at New York University’s Stern School of Business, are chief economists on the Atlas Capital team; and CEO of Rosa & Rubini Associates and visiting professor at Bocconi University.