Long Is the Way Out of the Global Inflation Fight, and Hard

had a pretty high class set of speakers. Axel Weber, the former head of the bundas Back now a senior adviser to UBS, the investor Davode Sarah, chief executive officer and founder of Algebra's Investments, and Geter Gopinath, formerly the chief economist of the i m F, now it's first deputy Managing Director. Of course we're talking about inflation. We could have spent a lot of time talking again about why central banks have got things so wrong, but I

was pretty keen to look ahead. What's the consequences of this inflation that we're seeing and does it mean we have to rethink some of the macro policy tool kit that we developed for a rather different time. I started, though, by asking Peter Governa, with her perspective at the International Monetary Fund, whether collectively policymakers had done enough to confront inflation.

I mean, stephaniely, without a doubt, one of the biggest challenges economies around the world are facing is inflation uh and to bring inflation down at the time when growth is also slowing for other reasons because of other forms of supply sharks. I think what central banks around the world have clearly recognized is that they need to move

in the determined fashion to durably bring inflation down. If you see the total amount of rate increases that we've seen in the US this past year, this is their few parallels in terms of the last several decades to see this much of an increase in such a short period of time, But I was needed to address the kind of inflation that we haven't seen in over four decades. The US FED is at the point where they've raised

interest rates around basis points. They are very likely to raise interest rates another round before the end of this year, and then the question is what comes next, And I think the question is more about how long are you going to keep these rates at the at the levels that they've moved them too, and we see a need to keep it at over four percent for all of twenty twenty three to be able to bring inflation down durably, and like you said, it's very important to do that

because it's extremely regressive high levels of inflation. Now, there are countries at other different points in their cycle, but I focused on the US because in terms of spiller was to the rest of the world, US policies had

the biggest effect. Actually, you're the former central banker on this panel, and we should record that you were on the record early in morning about inflation at the end of But you have now had at least ninety central banks raised interest rates this year, at least half of them basis points in a single go, which most of them have not done before. Are we now at a point where central banks can have a more leisurely We're

not talking pivots, but a more leisurely pace. No. I think, as Gito was indicating as a central banker, seventy five basis point moves are usually conducted over the last couple of decades. Only on the way down. When you are ever been hit by a shock and you were behind the curved by construction because something unexpected in the economy,

like in the financial crisis, on the way up. I think it's a mirror image and and we don't want to talk about the past, but it's a bit of a mirror image of being laid in my view, by design from the inflation targeting regime that was adopted and therefore having to do faster steps because inflation didn't just rise from below two percent to just above two percent or three percent or four percent, when all the way up to double digit and that's where I think a

lot of action was needed. If if central banks have a dual mandate, which many of them have explicitly or implicitly, the most violated objective in the central bank objective function at the moment is inflation. It's way out of line with the target, whilst the employment and the economy has been holding up relatively well so far. And there is a new shock with the war in Ukraine that has added another negative supply shock to an already strained environment

that that central banks were facing. So I don't think they're done. I think they've got some more work to do. I think the belief in markets that central banks will go and then come back in next year is in

my view, uh, both premature and not ideal. From a central bank point of view, and with GETA, they probably have to keep rates at which they go over the spring next year at that level for the remainder of the year and into twenty four to bring inflation down towards they're objective, and it will take them two years to really be in the vicinity again of their objective

bearing further shocks. But bearing further shocks is a very brave assumption, and a lot of the things that are in the pipeline, the transition to a greener economy, all of this will have inflationary impacts on energy prices and in other parts of life. So I think there is a likely scenario where you will see repeated shocks that will keep inflation eye and more persistently high, despite central banks having adjusted monetary policy and having raised rates substantially

at least for the next year or two. And as we know it's been discussed this week, it's not just the moved to net zero, it's climate change itself also produces more volatile inflation. I think we're pretty clear on that Tai day from the investors standpoint, where where do you think we are on this road? I think investors right now have this view, at least what's priced in

the future, the rates are going to go lower. But here the beauty of Bank of England that has calculated numbers for the last five century is never in developed markets when core inflation passes five for more than twelve months, they're being able to bring the core inflation number below too in less than ten years. Only once in history in the last century in less than five years. So if history is of any help, I think rates are going to stay higher for longer, and there are free

reason for it. The inflation shock comes from free main area. The first one is green transition. The second is the decaupling of the supply chain globally for geob political reason. And further, remember green transition require materials which are no longer in an abundant space. You know, think about copper. We'll be looking for copper for two thousand years. We need to find more copper in the next twenty years that we've been found in the last two thousand years.

And when you add then the add there's consequences of getting in transition and climate change on food, you add minerals, and then you add the war, you're creating an effect that's why I think inflation is going to be strategy. It's slightly higher. Then if you think that we had in developed market US and Europe, now people have better balance sheet. You see it in the US, so a recession is likely to be less, you know, shallow. We're not going to be a harder recession. And as a

result of thin, central bank can keep rates higher. So I think if the market is wrong, rates ain't going to go down as stats as people think, in the sense it is running together both things, as the current inflation shop where people are dealing with, and then these longer term trends, and people have thought that maybe this was a sneak preview to those, But he's kind of saying, we're already there, guitar, Do you buy into that that

we we're already in this structurally higher inflation world. Not fully. I would say the following, which is what is true, is we are likely entering a period where supply sharks will play a bigger role then they did in the last two decades. And supply sharks include sharks that come from a climate. But also I think risks in terms of economic fragmentation around the world. What could happen to global trade. I think those risks could play an important role.

So we probably are entering an error where for central banks they really have a trade off to deal with. They didn't have a trade off. I mean it was for the last couple of decades they could keep reducing the unemployment rate and not see any inflation. They didn't really have a trade off to deal with. But now they actually are likely to have a most serious trade

off to deal with. But the question of the inflation that we've seen now, I wouldn't not start with the green transition of climates as being the leading factor for it.

I think what we had was a very unique period of the pandemic now the war and we've seen very extraordinary recoveries that have come along with very large amounts of support that was provided during the worst time of the pandemic in terms of both money, ships policy support, and also especially fiscal policy support, so people with high levels of savings, and now you've seen that money being spent alongside you do have a supply side problem to which is that in markets like the US and the UK,

labor supply hasn't come back to what it was pre pandemic. You still have the pandemic hitting other parts of the world. In China, we in cases going up that's affecting supply chains. So I think those are the main factors. I still do believe monetary policy works in the traditional way of reducing demand by raising interest rates, and we are seeing that happen in in the U S and other countries. It's going to take some time. I don't think it's

going to take many, many decades like that. And they said, but again, um, so I would make that distinction. I mean, but what we're trying to solve now and what the risks are there on the horizon? Accellent. We're focusing on policy making. Um clearly we've seen I mean the UK had some of its own problems, but it also there was a structural issue which many countries face of balancing now in this more challenging world, the fiscal and the monetary.

Do you think we have the right sense of what that how fiscal and monetary needs to work together or not work together in this environment. Yes, So two things, and I need alluded to it. One thing you have to see is that what happened after COVID, namely a massive expansion of balance sheets of government and finance, largely by emissions and purchases of sovereign debt into the balance

sheet of a central bank. Was a coordinated extension of balance sheets on the sides of the central bank, roughly to the tune of of global GDP and of governments, and a lot of that, unlike in the financial crisis, was going to private households in forms of paychecks and really increased demands. So there was quite a demand stimulus that we saw necessarily so in but he was kept in place, at least from the monetary side, way too long, and I think that is part why we saw inflation.

The other side we haven't talked about is the balance sheets really what will happen with them in the future. Now, if you look at the S and P five, then you look at the you know, added balance sheet of the major three central banks Europe, Japan and the US, you see a very high correlation between how financial markets have been performing and the liquidity put into the system by the central banks. Now, going forward, central banks don't

just raise rates, they're also reducing their balance sheet. And actually, if you look at Europe, because some of the liquidity was provided through long term financing, operations that have an

end date and not been prolonged. A lot of the success liquidity will go relatively fast in the short period of early next year, and then the reduction or balance sheet will add to a down draft that will continue to draw liquidity structurally out of the markets, and so the price for liquidity and the price for investments will in my view in the future be quite a bit higher. What you saw in the UK was actually because of

a financial stability concern. The central Bank that was actually on course for reducing its balance sheet had to intervene in the market and pump liquidity in for three days, as Andrew Bailey announced at the IF meeting in Washington, d C. In order to stabilize some of the UK pension funds that use derivative instruments and therefore got an

exposure to strong movements in financial markets. So I wouldn't be surprised if we have further episodes in the market were that combined great increase and withdrawal of liquidity will lead to pocket of weaknesses in financial markets because of leverage strategies getting cold and not being able to be continued as they are. How dangerous is it to have

quantitative tightening. The shrinking of central bank balance sheets continued, and we had traditionally said it was a tool when the balance sheet was going out, and it was a tool that was less well understood than the impact of interest rates. So is it dangerous for central banks to keep plowing ahead? I think it's dangerous if they don't understand where the leverage is. And so I think we will probably see central bank keeping the assets they have.

By the way, for ten years we haven't seen inflation. So the world is designed to have inflation around two to three. We had zero for ten years. It's great that we're gonna have free four for the next tent. It's just simply that you know, when you do an average over twenty years, probably the an average is gonna end up being about right. Yeah, And hence we need some inflation because the only way to deflate that to

GDP is for inflation. That's always happening in history. One of the places you look to think about hidden financial stability risks is the i m FS PLAY Financial Stability Report. Do you do you agree that we put there are potentially some sort of unexploded consequences out there for the quantitative tightening in central bank balance sheets. Well, I think, well, without a doubt, there are significant segments of the financial market that live in the shadows that are not well regulated.

We call them non bank financial institutions, and that is where we are likely to be surprised. And that's what happened in the UK. So as our Global Financial Stability Report show that when you do a global stress test for the banking system, advanced economy banks are quite resilient too some very serious downside scenarios. Emerging market banks less so. So in a very severe downside scenario, which is in the GFSR, we have about thirty percent of emerging markets

who breach minimum capital requirements. That's a pretty serious event. But I think the real unknown is the non bank financial system, and that's exactly where we have hidden leverage, where we have uh, you know, dark corners, which which come up only when things get really difficult, like we saw in the UK. So that's something that we are

worried about. It more generally, in terms of the financial conditions at the moment, we see a distinction between you know, investment grade assets which everywhere around the world training are the spreads are quite low, they you haven't seen much movement there, but if you look at frontier markets, that's where you're seeing a lot of stress Already. We have about sixty of low income countries that are already in high debt distress, and I'm about of emerging markets now.

That does not make a systemic debt crisis for sure, but again, we're in very risky times, like the war is not over, the pandemic is not over, and we haven't won the fight against inflation, so interest rates may need to go up much more than any of us would like it. Argentina, Scott a lot of debt, a lot of it borrowed from the IMF. It has some of the highest inflation rates in South America. What's your

advice to them about how to balance those two? And I was just saying that there is no tension between what fiscal policy and monetary policy need to do. They're all have to go in the exact same direction, which is they have to be on the restrictive side. You know that part of the I am A program which working with the authorities that was green on, which is

you know what, Argentina, it tanks the economy. Sorry if it tanks the economy, then that doesn't support So there's one way that we know how to bring inflation down, which requires reducing demand in the economy. The Argentina economy is growing at a healthy rate, it's there are headwinds to it at this moment also from external shocks. But you know, having inflation now is over sevent and if we want to have durable growth, we know that you

need to bring inflation down. So just to make a point to a dry said, which is inflation helps with debt to GDP, clearly not the case on a long term basis. Argentina for instance, as an example, where once you live in a high inflation environment, that gets priced into your interest rates and then there's no gain at

all in having that kind of inflation. So yes, you have a very short term benefits because there's surprise inflation and you're you've boarded low rates and you have surprised inflation. So you can bring that to GDP down. But from the experience, we know that is not a durable way to bring that to GDP down and Argentina. Argentina is

an outlier here. If you look at actually what getas job would be in in any of the previous cycles, you would have not seen the stability of many of the emerging markets that frontloaded some of the interest rate increases before the established central banks did in order to prevent outflows from their markets into the US and other market. Emerging markets have been amazingly resilient so far. But the problem is this frontier markets that the weakest and poorest economies,

because they're facing massive distress. There is a likely rating cycle that is going to set in where even those that are just about investment grade might get downgrades to sub investment grade. The s from rising interest rates on these markets, which are the poorest economies of this world.

It's going to be massive. Are We're gonna be talking much more about sovereign debt and developed and developing economies next year, having spent the last year really focused on monetary policy, not in development market because I think we've seen in the UK yours. No, because I think there's one advantage currency. Remember, the candacy market is adjusting fast.

You have seen it in Europe. You know we're paying five to six percent for hydro carbon ut gas and oil more compared to the United States, and immediately the cadency is adjusted in the UK, the panther is adjusted fast of the last twenty thirty years. In the gaping productivity, I think an image market, and there's a distinction those the producer that our food producer are in a good shape. The issue here with the war is those that don't have enough food that we need to import food, so

sub Sahanan, Africa, Egypt, the industry Lanca. So if they have a problem in the food supply chain with rising rates and high level of that, it might end up being an absolute catastrophe. And so I think here actually where we need to be all worried. Well, I think

that just alluded to something very important. We're starting to see the first round effects of inflation come off, and why Central Max have to keep at it is to prevent second round inflation very effects and from this to become embedded in the wage price mechanism of the economy, because once people start believing they should index their contracts to four or five percent inflation as opposed to that's where it becomes very long lasting and embedded in the economy.

And that's why in the in the seventies it was so hard to get rid of inflation because it had become embedded in the economy. We still have the chance to prevent that, but it requires determined action that markets and market participants will see inflation is going to colm down over a reasonable period of time, not the decade. I would say two years, three years at the most.

That helps you anchor inflation expectations. They have not run away, so we're not yet lost this inflation battle, but I think we need to be really focused on that now for the for the period to come, at least for the next couple of months. Peter, just a quick response to that, So, I mean, do you do you agree that we've dealt with the first round, but we still

need to be very cautious about second round effects. But I think also what damadays say, because we've had warnings from the European Central Bank just in the last couple of days, do you agree that there's not likely to be any issues around sovereign debt in the Eurozone in the next year or two. So agree with Axcel on the fact that it is very important for central banks

to stay the course. We've had false dawns before. One in good inflation reading does not make a trend, and we have enough lessons from history of central banks who have kind of moved changed course too quickly UH and then created an even bigger problem that required grinding the economy to hold an even deeper recessions UH than would

have happened if they had just stayed the course. So I think that's absolutely right, and we are there at this point that we should this interrom actial state of course in terms of sovereign death issues in UH in the UR area. Firstly, I think that there have been a lot of important developments in the European Union in the your area compared to the previous the GFC. You have your stability mechanism that is there to help countries

deal with surprise events or sudden tightening market liquidity. The ECB has put in place a transmission protection mechanism, which is you know, which is will help them UH raise interest rates but ensure that you don't have very disorderly market conditions in certain sovereign debt markets. So I think that they have more instruments in place, that better mechanisms

in place to protect themselves to stand run. But but there's still question routes about Italy or your Do you think we're on the path now where Italy will be able to sustain the kind of increase in borrowing costs we've seen. I think we're in a time when there is a lot of uncertainties. So, like I said, the war is not over. We haven't seen the end of the energy crisis. This winter is turning out to be warmer and that really helps, but the bigger problem is

next winter. So all of that means that the ability to raise resources to repay your death you know, those those challenges will remain, uh, you know. At the same time, I do think that there's been improvement in policymaking, and there's been an improvement in institutions that you help see guard against worst outcomes. Petty company as Sarah Banks Favor, Thank you, so thank you. That's it for these mini episodes from the New Economy Forum in Singapore. Stephanomics will

be back from London next week. Meantime, check out at Economics on Twitter and the Bloomberg News website and terminal for all our economic news and analysis. This episode is produced by Yang Yang and the executive producer of Stephanomics is Mike Sasso.