Central Banks Poised for ‘Forceful’ Hyperactivity? – Mike Dolan, Reuters

By Mike Dolan

LONDON – The unpredictable fluctuations in inflation, without corresponding impacts on economic output, could become a hallmark of our post-pandemic reality marked by fragile supply chains. This scenario may necessitate more aggressive and reactive measures from central banks, potentially in both directions.

The global inflation surge triggered by the dual crises of COVID-19 and the Ukraine conflict has now been largely followed by a phase of disinflation. Central banks are rapidly adjusting their previous interest rate hikes aimed at controlling prices in 2022 and 2023.

Despite these volatile swings, the economy seems to be on track for a "soft landing," avoiding any significant overall output contraction. Policymakers, as well as businesses and financial markets, are left to ponder whether we’ve merely reverted to an earlier state while narrowly avoiding a severe crisis.

Reflecting on this situation, the Bank for International Settlements (BIS) presented an outlook hinting at a world where supply shocks may become more common and inflation less predictable. In a recent speech in London, BIS Deputy General Manager Andrea Maechler indicated that central banks might need to reconsider their tendency to dismiss supply shocks as mere temporary nuisances, a perspective they often held prior to the pandemic.

She highlighted that the current economic landscape features steeper supply curves and a more pronounced "Phillips Curve," which illustrates the connection between unemployment and wages, or more broadly, output and prices. The essence of her argument is that these steep supply curves lead to more significant price changes for any shifts in output, notably illustrated by labor shortages in the post-pandemic era that resulted in wage increases for companies eager to expand.

Additionally, disruptions to overseas supply chains, particularly following energy price surges after the Ukraine invasion, have created situations where rising production alongside supply shock has had a more profound impact on prices than observed in the past.

Maechler pointed out that the repercussions for broad economic inflation were more severe and quick due to the fact that they emerged during a period when overall inflation already exceeded central bank targets. She suggested that central banks should be cautious in determining how much they can overlook supply shocks.

This careful approach becomes increasingly relevant in a world characterized by de-globalization, geopolitical tensions, declining workforce numbers, rising public debt, climate change, and the shift toward green energy.

An active and robust policy response may be essential to maintain stability against the backdrop of short-term volatile inflation and to uphold confidence in long-term inflation targets.

Interestingly, the steep supply curves could also suggest that both wages and prices may return to target quicker, with only minor hits to output from rising interest rates. According to Maechler, increasing policy interest rates in reaction to adverse supply shocks might have limited effects on economic activity if the Phillips curves are indeed steep. This implies that tempering inflation could potentially be achieved with minimal economic cost.

However, the implications of these observations in the current environment remain uncertain, particularly amidst heightened geopolitical tensions. It remains to be seen whether the steep supply curves evident in the post-pandemic landscape will persist or if the anomalies will stabilize over time.

Should inflation unexpectedly drop below targets again, potentially threatening price stability, central banks may need to increase their intervention. Recently, European Central Bank policymaker Mario Centeno highlighted the risk of falling short of target inflation, which could hinder economic growth.

Similarly, new leadership at the Swiss National Bank indicated openness to returning interest rates to negative territory in light of falling monthly prices and annual inflation dipping below 1%. Even the Bank of England, among those previously hesitant to change course, is considering a more aggressive approach to rate cuts.

For investors, these trends suggest a more unpredictable interest rate landscape than what was experienced in the decade before COVID-19. Nonetheless, if broader economies can successfully navigate fluctuating prices and borrowing costs, there may be positive outcomes for corporate earnings and equity markets in the future.

The views expressed in this article are those of the author, a columnist.