- Central banks are determined to conquer inflation, even if the last mile to price stability may be the most challenging.
- There is a material risk of further financial stress as the financial system adjusts to the end of low-for-long interest rates.
- To safeguard stability and trust, monetary and fiscal policy must operate within a “region of stability”.
Inflation has started to subside from multi-decade highs almost everywhere, but the work of central banks is far from done, the Bank for International Settlements said in its flagship economic report. Despite the most intensive monetary policy tightening in recent memory, the last leg of the journey to restore price stability will be the hardest.
According to the BIS’s Annual Economic Report 2023, the gains made so far in the fight against inflation owe much to supply chains easing and commodity prices falling. But labour markets are still tight and price growth in services has proved harder to tame. There is a material risk that an inflation psychology will take hold, where wage and price increases start to reinforce each other. Interest rates may need to stay higher for longer than the public and investors expect.
The report analyses the risks posed by the unique mix of high inflation and financial stability risks. Central banks are tightening against a backdrop of high debt and asset prices, a legacy of risk-taking in financial markets when interest rates were low for long.
Bank closures in early 2023 were the most striking example of such risks materialising but far from the only one. Hidden leverage and liquidity mismatches in the non-bank financial sector are another vulnerability. If central banks must tighten more or for longer to achieve price stability, the risk of financial stress will grow.
“The key policy challenge today remains fully taming inflation, and the last mile is typically the hardest. The burden is falling on many shoulders, but the risks from not acting promptly will be greater in the long term. Central banks are committed to staying the course to restore price stability and protect people’s purchasing power,” said Agustín Carstens, General Manager of the BIS.
Fiscal and prudential policies can do their part to help stabilise the economy and the financial system. Governments should tighten their budgets, while targeting support on the most vulnerable, and embarking on a long-term consolidation of their spending. This would help curb inflation and keep financial stability risks in check by reducing the need for central banks to keep rates higher for longer. Regulatory and supervisory authorities can deploy the full range of tools at their disposal to strengthen the financial system, giving central banks more room to manoeuvre.
The report discusses how high inflation and financial vulnerabilities are signalling that monetary and fiscal policies are testing the boundaries of the “region of stability”. The ultimate risk of drifting outside that region is to lose the trust that society must have in the state and its decision-making. In the longer term, policy adjustments and institutional safeguards are needed to ensure that monetary and fiscal policies remain firmly within the region of stability.
“The current tensions are the culmination of decades of reliance on monetary and fiscal policy as de facto engines of growth. Overcoming this ‘growth illusion’ fallacy and finding a coherent policy mix requires a change in mindsets, recognising the limitations of stabilisation policies,” said Claudio Borio, Head of the BIS Monetary and Economic Department.