The fight against inflation by central banks worldwide could be facing a significant shift in strategy, according to recent comments by the deputy head of the International Monetary Fund (IMF).
As an influential financial authority, the IMF’s perspective could significantly impact the tactics central banks use to combat rising inflation rates.
Enduring inflation to ward off financial crises
At the annual European Central Bank (ECB) meeting held in Sintra, Portugal, Gita Gopinath, Deputy Managing Director of the IMF, signaled that the persistent battle against inflation might require a new approach.
The IMF suggests that central banks worldwide might need to endure periods of inflation exceeding their 2% target. This approach aims to prevent a financial crisis, particularly amongst nations burdened with high debt.
With European nations’ towering debt levels, the risk of financial upheaval is heightened. Gopinath noted that it’s crucial to understand inflation may linger above desired levels longer than anticipated, an “uncomfortable truth” policymakers must confront.
As the IMF sees it, entrenched inflation could become an increasingly prominent concern.
For governments unable to muster the fiscal or political means to tackle this issue, the IMF suggests that an adjustment in the monetary policy reaction function might be required.
However, this change in policy would necessitate a strong rationale. Historical events, such as the entrenched price growth experienced in the 1960s U.S., indicate that allowing inflation to exceed targets could lead to a more stubborn inflationary environment.
Potential impacts and required actions
The financial distress in the eurozone, warned Gopinath, could result in varying regional impacts. The mounting concern is the possibility of increased spreads in high-debt economies, compounded by other vulnerabilities like significant household debt and a high proportion of variable-rate mortgages in certain countries.
Despite the risks associated with tolerating higher inflation, the IMF urges central banks to remain vigilant against persistent inflation signs. Even if tackling inflation results in a substantial slowdown in labor markets, Gopinath advised that the ECB and other central banks should be ready to respond decisively.
The ECB has made significant strides in this regard, raising its benchmark deposit rate at a record pace. However, governments can also contribute to the inflation battle by cutting back deficit-funded spending, reducing demand, and thereby decreasing the need for the ECB to hike rates.
Furthermore, Gopinath recommended implementing new rules for EU governments to reduce their budget deficits and debt levels, which have soared in many countries. A unified deposit insurance scheme for all eurozone banks is also suggested to replace the current assortment of national systems.
In sum, the IMF’s advice to central banks to tolerate higher inflation as a strategy to avoid potential financial crises is a noteworthy shift in the battle against inflation.
As nations around the globe grapple with economic recovery amidst pandemic-related pressures, this shift in strategy could set the stage for how global economies navigate the path to financial stability.
