The message from the world’s top finance chiefs is loud and clear: runaway inflation is here to stay and getting it under control will take an extraordinary effort, most likely a recession with job losses and market shocks emerging.
This price is still worth paying. Central banks have spent decades building their credibility on their inflation-fighting skills and losing that battle could shake the foundations of modern monetary policy.
“To regain and preserve confidence, we need to bring inflation back to its target quickly,” said Isabel Schnabel, a member of the board of the European Central Bank. “The longer inflation stays high, the greater the risk that the public will lose faith in our resolve and ability to preserve purchasing power.”
Banks should also continue even if growth suffers and people start losing their jobs.
“Even if we enter a recession, we have almost no choice but to continue with our policy,” Schnabel said. “If there were a deanchoring of inflation expectations, the effect on the economy would be even worse.”
Inflation is near double-digit territory in many of the world’s largest economies, a level not seen in nearly half a century. With the notable exception of the United States, a peak is still months away.
The complication is that central banks mostly seem to have only limited control.
On the one hand, high energy prices, a function of Russia’s war in Ukraine, create a supply shock on which monetary policy has little effect.
Excessive government spending, also outside central bank control, is exacerbating the problem. A study presented in Jackson Hole claims that half of US inflation is fiscal in origin and that the Fed will not be able to control prices without government cooperation.
Finally, a new inflation regime could take hold and maintain upward pressure on prices for an extended period.
De-globalization, realignment of alliances due to the Russian war, shifting demographics and more expensive production in emerging markets could all make supply constraints more permanent.
“The global economy appears to be on the cusp of a historic shift, as many of the tailwinds to global supply that have been limiting inflation look set to turn into headwinds,” said Agustín Carstens, director of the Bank for International Settlements.
“If that’s the case, the recent pick-up in inflationary pressures could prove more persistent,” said Carstens, who heads a group often called the central bank of central banks of the world.
All of this points to rapid interest rate hikes, led by the Fed, with the ECB now trying to catch up, and high rates for years to come.
The pain of high rates in the United States will reverberate far beyond the domestic economy and hit emerging markets hard, especially if high rates prove to be as long-lasting as Powell is now signaling.
“For the Fed right now, this is the critical moment,” said Peter Blair Henry, professor and dean emeritus of New York University’s Stern School of Business.
“The credibility of the last 40 years is at stake, so they’re going to bring inflation down no matter what, including if it means collateral damage in the emerging world.”
Many emerging countries are borrowing in dollars and the Fed rate hike has hit them on several fronts.
It drives up borrowing costs and raises debt sustainability issues. It also funnels liquidity into US markets, driving up emerging market risk premia, making borrowing even more difficult.
Finally, the dollar will continue to appreciate against most currencies, driving up imported inflation in emerging countries.
Larger countries like China and India seem well isolated, but a multitude of smaller countries, from Turkey to Argentina, are clearly suffering.
“We have a number of particularly frontier economies and low-income countries that have seen their spreads increase to what we call distressed or near-distressed levels, so from 700 basis points to 1000 basis points” , said Pierre-Olivier Gourinchas, chief economist of the IMF.
“There’s a large number of countries, it’s about 60% low-income countries, we have about 20 emerging and frontier economies that are in a situation,” he said. “They still have market access, but borrowing terms have certainly deteriorated a lot.”
A monitor from S&P Global (NYSE:SPGI) now rates the funding risk of lenders in South Africa, Argentina and Turkey as high or very high. It also considers the credit risk of financial firms to be high or extremely high in a host of countries, including China, India and Indonesia.
“There are a few frontier economies like Sri Lanka, Turkey and so on that are going to get hammered if the Fed raises rates and rates stay high,” said Eswar Prasad, an economics professor at Cornell University. .
“A two- to three-year horizon will start to make things difficult…If it becomes clear that the Fed is going to keep rates high for a long time, the pressures could be felt immediately,” Prasad added.