The next revolution

Monetary policy, Milton Friedman said, acts on the economy with long and variable lags. Just as important for investors is that the reverse is also true. Monetary policy regimes evolve in response to the changing nature of prevailing economic challenges – though this also takes time. The great debate of the current era is whether the inflation-targeting central banks established in the 1990s are still fit for purpose in the ultra-financialised economies of the 2020s. In the past week, both the International Monetary Fund and the Bank for International Settlements have made striking interventions. Investors should take note. The next revolution in monetary policy may be brewing.

Start with the IMF. At the European Central Bank’s annual get-together in the Portuguese village of Sintra on Monday, Gita Gopinath, the fund’s deputy managing director, urged policymakers to confront what she called some “uncomfortable truths”. Foremost amongst these is that since central banks began hiking interest rates in late 2021 they have exposed a string of unexpected financial stresses.

Last October, UK markets descended into turmoil as margin calls on leveraged investment strategies caused British pension funds to panic-sell government bonds. A month later a default by a South Korean Legoland theme park developer triggered an economy-wide credit crunch in the Asian country. Jitters caused by higher borrowing costs also contributed to the failures of lenders like SVB Financial and Signature Bank in the United States and Credit Suisse in Europe.

Central banks can relatively easily limit the impact of problems arising in the financial sector. Containing the fallout from rate hikes in other parts of the economy is much more tricky, Gopinath warned.

As if on cue it seems that Thames Water – the UK’s largest water and sewage utility, responsible for supplying nearly a third of the population of England and all of London – is on the brink of insolvency. The root problem is its inability to service 14 billion pounds of debt accumulated during the low-interest rate era. The impact of inflation-fighting rate hikes has quite literally reached the capital’s kitchen sinks.

The rolling cascade of financial accidents has undermined the credibility of policymakers’ hawkish rhetoric. As a result, sizable gaps have regularly opened up between market expectations of future policy rates – as conveyed, for example, by Fed Funds futures in the United States – and central bankers’ own projections. Investors are sceptical that central banks can make good on their inflation-fighting promises.

On Monday, Gopinath urged policymakers to regain the initiative by acknowledging that markets have a point. In a world of gargantuan public and private sector balance sheets, there is indeed a trade-off between controlling inflation and maintaining financial stability.

The implication is that central banks should tolerate above-target inflation in the short term in order to restore price stability in the medium term without causing a financial catastrophe along the way. Though no senior IMF official would ever put it so bluntly, a modest dose of financial repression is the least bad option until the necessary deleveraging has taken place.

One question Gopinath did not address is how the financial system came to dominate monetary policy. Fortunately the Bank for International Settlements’ Annual Economic Report, published the day before her speech, covers that.

The BIS argues that the problem ultimately derives from three decades of unrealistic expectations about what monetary and fiscal policy can actually achieve. The institution known as the central bankers’ bank labels this fallacy the “growth illusion”.

Prior to 1990, financial systems and labour markets were more heavily regulated while international trade and capital flows were less free. That made inflation an accurate barometer of the stance of monetary and fiscal policy, and meant financial imbalances were relatively contained as a result of policymakers’ symmetric reactions to booms and busts. If policy was excessively loose, inflation would rise, so policy would tighten again – and vice versa. This process of continuous error-correction kept economies within a relatively tight “region of stability”.

But financial and economic globalisation after 1990 relaxed supply constraints, scrambling the signals on which this self-stabilising system depended. As strong aggregate demand no longer led to inflation, policy became asymmetric. During expansions, there was less incentive to raise interest rates or tighten public finances. When contractions hit, however, central banks eased monetary policy and governments loosened their purse strings, just as before.

The result, the BIS argues, was a vast expansion of the apparent “region of stability”, and a continuous loosening of monetary and fiscal policy. That era has now come to an end. The U.S. confrontation with China, the Covid pandemic, and Russia’s invasion of Ukraine have thrown the decades-long relaxation of supply constraints into reverse. The “region of stability” has snapped back to a fraction of its former size. As a result, the developed world now faces both the high inflation characteristic of the pre-globalisation era and the financial vulnerabilities familiar from more recent decades.

This epic analysis has much deeper policy implications than Gopinath’s proposal to trade higher inflation for more financial stability.

The first is that inflation-targeting itself is part of the problem. By focusing exclusively on price stability, policymakers ignored growing financial fragility. A fundamental rethink of policy frameworks would put preserving financial stability on an equal footing with controlling inflation in central bank mandates.

The second is that statutory independence did not prevent central banks from falling under the spell of the “growth illusion”. In fact, the BIS analysis implies that feedback mechanisms keeping the economy in the “region of stability” were more powerful in the days when elected politicians set interest rates. In other words, much derided “stop-go” policies ultimately led to lower long-term risks than inflation-targeting.

The BIS is too reticent to draw out these conclusions explicitly. That implies a full-scale revolution in central banking is still some way off. Then again, if the last decade has taught us anything, it is not to be complacent. For inflation-targeting as we know it, Gopinath’s modest proposal might be the first step towards the guillotine.