By THÉRÈSE MARGOLIS
Former Central Bank of Mexico (Banxico) Governor and current General Manager of the Bank for International Settlements (BIS) Agustín Carstens said Tuesday, April 5, that, like it or not, inflation is here to stay, at least for the foreseeable future.
Speaking before the International Center for Monetary and Banking Studies in Geneva, Switzerland, Carstens, who served as the Banxico’s governor from 2010 to 2017, said that as a result of global disruptions in supply chains due to the impact of covid-19 and Russia’s brazen military invasion into Ukraine, inflationary pressures have become a major international concern and could persist for several years.
“After more than a decade of struggling to bring inflation up to target, central banks now face the opposite problem,” he said. “The shift in the inflationary environment has been remarkable. If you had asked me a year ago to lay out the key challenges for the global economy, I could have given you a long list, but high inflation would not have made the cut.”
Carstens went on to say that the rise in inflation over the past year came as a big surprise for most economists.
“A key message is that we may be on the cusp of a new inflationary era. And the forces behind high inflation could persist for some time,” he said.
“New pressures are emerging, not least of all from labor markets, as workers look to make up for inflation-induced reductions in real income. And the structural factors that have kept inflation low in recent decades may wane as globalization retreats.”
As a result, Carstens, who also served as executive director of the International Monetary Fund (IMF) from 2003 to 2006 and Mexico’s secretary of finance from 2006 to 2009, warned that under this new inflationary panorama, “central banks will need to adjust, as some are already doing.”
“For many years now, having conquered inflation, (central banks) have had unprecedented leeway to focus on growth and employment,” he said. “But this is now no longer possible, since low and stable inflation must remain the priority. If circumstances have fundamentally changed, a change in paradigm may be called for.”
Carstens said that the change will require “a broader recognition in policymaking that boosting resilient long-term growth cannot rely on repeated macroeconomic stimulus, be it monetary or fiscal,” and will only be achievable through government structural policies that strengthen economic productivity.
Most notably affected by the jump in inflation have been advanced economies (AEs) like the United States and countries in Western Europe, Carstens said.
“Indeed, almost 60 percent of AEs currently have year-on-year inflation above 5 percent – more than 3 percentage points above typical inflation targets,” he said.
Notwithstanding, Carstens said that it is important to understand that inflation is a global problem, particularly effecting emerging market economies (EMEs), where inflation rates are now generally above 7 percent.
“Admittedly, the rise in inflation has not been uniform. In Asia, for example, inflation has generally risen less,” he said. “But even in that region, most countries – with the exception of Japan and China – have seen a material pickup in recent months. And even here in Switzerland, once dubbed ‘the country that inflation forgot,’ inflation is the highest since 2008.”
And while initially global inflation was confined mostly to durable goods and energy, Carstens said that the phenomenon is now increasingly broader-based. In particular, he said, there have been surges in service prices.
“Because growth in service prices tends to be more persistent than that in goods, inflation may be becoming more entrenched,” Carstens said.
Taking this situation into account, Carstens said that the central banks will have to continue adjusting their benchmark interest rates, just as Banxico and the U.S. Federal Reserve have done.
Banxico has raised its interest rate seven times in a row, of which the last three times were by 50 basis points, with the Mexican benchmark currently at 6.5 percent.
“Central banks may also need to reassess how they respond to inflation resulting from supply side developments,” Carsten said. “These will typically spark relative price changes at first. The textbook prescription is to ‘look through’ this type of inflation, because offsetting their impact on inflation would be costly. But that assumes inflation overshoots are temporary and not too large. Recent experience suggests it can be hard to make such clear-cut distinctions. What starts as temporary can become entrenched, as behavior adapts if what starts that way goes far enough and lasts long enough.”
Carstens said that it will be “hard to establish where that threshold lies, and we may find out only after it has been crossed.”
But the good news, he said, is that central banks are well aware of the risks.
“No one wants to repeat the 1970s,” he said. “It seems clear that policy rates need to rise to levels that are more appropriate for the higher-inflation environment. Most likely, this will require real interest rates to rise above neutral levels for a time in order to moderate demand.”
He also admitted that an adjustment to higher interest rates would not be easy.
“In many countries, starting conditions complicate matters. Households, firms, financial markets and sovereigns have become too used to low interest rates and accommodative financial conditions, also reflected in historically high levels of private and public debt,” Carstens said. “It will be a challenge to engineer a transition to more normal levels and, in the process, set realistic expectations of what monetary policy can deliver.”
The required shift in central bank behavior will not be popular, he said, but central banks have been through similar situations and will be able to maneuver inflation, although they will require additional assistance from governments and the private sector.
“The key to higher sustainable growth cannot be expansionary monetary or fiscal policy,” Carstens concluded.
“We must strengthen the productive capacity of the economy. Indeed, this is well overdue. Many of the economic challenges we face today stem from the neglect of supply-side policies over the past decade or more. Over the medium term, higher potential growth would make it easier for indebted economies to withstand the higher nominal and real interest rates that are likely to prevail in the years ahead. Central banks have done more than their part over the past decade. Now is the time for other policies to take the baton.”