1. The challenge of global inflation
Inflation was subdued across the global economy prior to the pandemic, with global inflation averaging 2.7% over the course of the 2010s. However, price growth started to accelerate as the economy recovered from the pandemic, before the prices of key commodities, such as food and energy, were further impacted in the wake of the Russian invasion of Ukraine. The IMF is now forecasting that global inflation will be 8.8% in 2022, up from 4.7% the previous year.
The rise in inflation presents a challenge for central bankers formally tasked with maintaining price stability. Governor of the Bank of England Andrew Bailey noted in May 2022 that “there isn’t a lot we can do” about much of the increase in inflation, given that it was caused by a “sequence of shocks” that the Bank had no control over. Nevertheless, the magnitude and persistence of the increase in inflation has led the Bank of England, along with other central banks, to take significant action to tighten monetary policy by raising interest rates. By taking this action, the Bank is attempting to ensure that expectations for a high rate of inflation do not become embedded, and that “longer-term inflation expectations are anchored at the 2% target”.
2. Policy trade-offs
A number of commentators have noted the challenges associated with the interest rate rises. Writing in the New York Times, economic historian Adam Tooze notes that there is no historical precedent for the current situation. The last major monetary policy tightening on a global scale took place in the 1980s. But since then there has been a wave of economic and financial globalisation which, he suggests, helped hold down prices and interest rates. This combination is now being reversed, and Tooze questions whether a global economy which is now “debt-laden”, after decades of loose monetary policy, can handle a serious rise in interest rates.
The ideal scenario—typically described as a ‘soft landing’—is considered by economists to be one where interest rates go up by enough to help bring inflation down but not by enough to cause broader collateral damage to the economy: for example, by reducing growth or increasing unemployment.
Tooze suggests a soft landing is possible but that it would require significant global coordination. He says this is because one of the key channels through which raising interest rates can help reduce inflation—appreciating the exchange rate—is essentially a zero-sum mechanism. High interest rates can cause a currency to become more attractive to global investors, due to the higher returns on offer, and a more valuable exchange rate reduces the cost of imports, a key determinant of inflation. The risk, according to Tooze, is that if central banks are left to tackle inflation on a country-by-country basis, they could descend into a “beggar-thy-neighbour” bidding war. This means that, due to concerns about protecting the value of their currency, central banks around the world could raise interest rates above what is needed to actually bring inflation down. Tooze suggests that global coordination of monetary policy could prevent this scenario and help ensure that the desired “disinflation” is as painless as possible.
In a Project Syndicate article, Nouriel Roubini casts doubt on the possibility of a soft landing for the global economy. He suggests that soft landings are historically unprecedented and that a ‘hard landing’—a euphemism for recession—should be the base case scenario if inflation is to be reduced back to target. Given the excess of debt in the global economy, he says there are significant economic and financial risks associated with sharply rising interest rates, with the issues in the UK gilt markets following the ‘mini-budget’ representing a prime example. Roubini suggests that the Bank of England’s intervention to buy gilts in response was an early sign of central banks “wimping out” of the monetary discipline they need to impose to reduce inflation. Given his scepticism regarding central banks’ willingness to tackle inflation, Roubini raises the prospect of a “protracted stagflationary debt crisis”, whereby interest rates are raised enough to cause economic and financial distress, but not by enough to effectively deal with inflation.
The academic Radhika Desai, writing for NLR Sidecar, challenges the framing of current global inflation as primarily a monetary issue. Desai claims that four decades of “neoliberal” policies—“disinvestment, deregulation, outsourcing”—have hollowed out productive capacity and rendered economies extremely vulnerable to supply-side disruption, therefore limiting the possibility for supply-side policy measures to bring prices down. In addition to this, she says the economy has become increasingly “financialised” over recent decades, with the size of the financial sector increasing relative to the rest of the economy, and the prosperity of non-financial companies becoming dependent on the maintenance of a permanent “asset bubble” underpinned by expansionary monetary policy. As such, Desai says that the drastic interest rate rises executed in the 1980s to reduce inflation are not a realistic option today.
Desai argues that a state-led programme focused on easing the supply constraints underlying the initial rise in inflation would be the only way to stabilise prices in a way which avoids a hard landing for the broader economy. However, she does not believe this policy approach is likely “within the parameters of the present system” given the scale of intervention it would entail.