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Confront inconvenient truths to fight global inflation

IMF official Gita Gopinath highlights the role of fiscal policy in potentially mitigating the side effects of combating inflation.
  • Stubborn inflation is linked to factors such as tight labor markets, strong wage growth, and pent-up demand, despite hikes in interest rates, says an IMF official
  • Monetary policy strategies and tools like forward guidance and quantitative easing may require adjustments to handle these risks effectively, adds Gita Gopinath

Frankfurt, Germany – Confronting inconvenient realities is critical in the war against inflation, said Gita Gopinath, the First Deputy Managing Director of the International Monetary Fund (IMF), while speaking at the European Central Bank Forum on Central Banking 2023.

Gopinath initiated her address by identifying three discomforting truths for monetary policy. Firstly, she noted that the struggle to bring inflation back to target rates has proven longer than anticipated. Despite hopeful forecasts, stubbornly high inflation persists across the Eurozone and other nations.

Comparing the situation to Samuel Beckett’s play, “Waiting for Godot,” Gopinath emphasized the necessity for central banks, including the European Central Bank (ECB), to steadfastly continue their fight against inflation, despite the associated risk of subdued economic growth.

The second truth Gopinath pointed out was the potential friction between central banks’ goals for price stability and financial stability. Although it’s feasible to maintain a balance between these objectives, it’s far from guaranteed due to potential financial stresses.

Gopinath’s third inconvenient truth was that central banks are likely facing greater inflationary risks now than they did pre-pandemic. Thus, monetary policy strategies and tools like forward guidance and quantitative easing may require adjustments to handle these risks effectively.

The First Deputy Managing Director also shed light on the root causes behind stubborn inflation, attributing it to factors like tight labor markets, strong wage growth, and pent-up demand, despite significant hikes in interest rates. She argued that financial conditions might not be stringent enough for effective monetary policy transmission, while the pandemic’s effect on potential output and productivity has compounded inflationary pressures.

Addressing the worrying ramifications of sustained high inflation, Gopinath underscored the likelihood of a shift in inflation dynamics that could complicate efforts to reduce inflation. Elements like wage catch-up and businesses’ reluctance to erode profit margins could impede inflation reduction and strengthen inflation expectations, thus increasing vulnerability to future cost pressures.

In her closing remarks, Gopinath urged central banks to face these uncomfortable truths head-on, and she reiterated the importance of the continued fight against inflation. The importance of refining monetary policy strategies and tools to address the ever-changing inflation risks effectively was also emphasized.

Gopinath’s speech at the European Central Bank Forum underlined the challenges central banks face in their ongoing battle against inflation, reminding us of the crucial role adaptive and vigilant monetary policy plays in maintaining global economic stability.

Gopinath also touched on the role of fiscal policy, suggesting that it could help alleviate some of the side effects of combating inflation through monetary policy. A broader, coordinated use of fiscal policy across multiple countries could help temper demand and limit the need for interest rate hikes. However, she cautioned against diluting deficit reduction plans, instead advocating for targeted support where necessary, and prudent management of revenue windfalls due to high inflation.

Gopinath acknowledged the daunting nature of the inflation fight but emphasized the crucial role that the return to price stability plays in achieving sustained economic growth. She expressed her optimism that with effective policy strategies and tools, central banks could successfully invite “an old friend” back, referring to low inflation, rather than waiting for an elusive stranger.