Uncoordinated monetary policies risk a historic global slowdown

Central banks nearly everywhere feel accused of being on the back foot. The present danger, however, is not so much that current and planned moves will fail eventually to quell inflation. It is that they collectively go too far and drive the world economy into an unnecessarily harsh contraction. Just as central banks (especially those of the richer countries) misread the factors driving inflation when it was rising in 2021, they may also be underestimating the speed with which inflation could fall as their economies slow. And, as often is the case, by simultaneously all going in the same direction, they risk reinforcing each other’s policy impacts without taking that feedback loop into account. The highly globalized nature of today’s world economy amplifies the risk.

Central banks clearly are scrambling to raise interest rates as inflation runs at levels not seen for nearly two generations (see the figure below). Just in the past week, the Reserve Bank of Australia raised its policy rate by 50 basis points, while the European Central Bank (ECB) hiked by 75 basis points. Another large upward move by the US Federal Reserve looms on September 21. Many emerging-market economies have extended tightening trends that they already began in mid-2021. Among the major emerging markets, only China, Russia, and—disastrously—Turkey are cutting interest rates, but their contrarian moves reflect very idiosyncratic factors.

A shifting Phillips curve complicates monetary policy

Key to understanding how central bankers think about inflation is the Phillips curve, a statistical correlation capturing the intuitive idea that the more productive resources are unemployed in an economy—the greater its degree of “economic slack”—the lower will be its inflation rate, other things being equal.[1] A steep Phillips curve, as prevailed in most countries during the high inflation of the 1970s, means that small variations in slack can give rise to sharp changes in inflation; a flatter Phillips curve means that inflation may change little even as unemployment varies widely. Economists agree that at least in advanced economies, Phillips curves became noticeably flatter between the 1970s and 1990s, and remained so until COVID-19.[2]

That development implied both good news and bad news for monetary policymaking. The good news was that when inflation expectations are stable, even large temporary variations in slack need not endanger price stability. The bad news was that once inflation expectations diverge from central bank targets, only large changes in activity and employment can restore inflation to target. As ECB Executive Board member Isabel Schnabel told the Jackson Hole symposium last month, “Today, a flat Phillips curve means that lowering inflation—once it has become entrenched—potentially requires a deep contraction.”

The belief in a stable flat Phillips curve—tied to belief in their own credibility of commitment to control inflation—helps explain why monetary policymakers failed to anticipate the current surge in inflation (even leaving aside the unforecastable Russian invasion of Ukraine).[3] It can also explain why they may be overestimating the monetary contraction needed now to tame price increases.

In reality, the Phillips curve may well have become steeper as economies reopened after COVID-19. In collision with high demand, supply-side pressures drove prices up while many central banks postponed forceful action and insisted that price pressures would be temporary.

But inflation can become self-fulfilling if it seeps into expectations unchallenged, changing the shape and location of the Phillips curve. Price inflation results from the actions of many businesses who set prices to cover expected production costs over coming quarters. If businesses expect cost pressures to persist for some time without central banks’ pushback, then excesses of demand over supply like those that emerged by mid-2021 can induce them to raise prices more quickly—a steepening of the Phillips curve. Estimates by Gita Gopinath of the International Monetary Fund suggest a steeper post-COVID inflation-versus-slack relationship across industrial economies.[4]

Globalization raises the stakes

Whether the Phillips curve will flatten out again quickly as central banks demonstrate more anti-inflation resolve is anyone’s guess. In her August speech, Schnabel argued that even if the Phillips curve is steeper for now, vanquishing inflation will still likely require harsh recessions because “the fact that it is often global rather than domestic slack that matters for price-setting reduces the sensitivity of the economy to interest rate changes on a much broader level.”

The “global slack hypothesis” is one of the leading theories advanced to explain a flatter Phillips curve since the 1990s. The proliferation of global value chains and global trade integration, reflecting a big increase in the share of international trade due to intermediate products, makes it plausible that foreign slack could lower import prices with knock-on effects for inflation. If so, inflation could depend more on foreign and less on domestic slack, attenuating the Phillips relationship between domestic inflation and purely domestic slack.[5]

If we accept the hypothesis that global slack matters for domestic inflation, then in current circumstances, it suggests that each central bank should be less rather than more zealous in raising interest rates. The reason is that central banks abroad, through their own inflation-fighting efforts, are also helping to dampen inflation at home. If central banks do not take into account that spillover in calibrating their own needs for higher interest rates, they will each overdo monetary tightening.[6]

While some economists dispute the hypothesis that global slack is an important independent determinant of domestic inflation, there is wider agreement that inflation depends increasingly on the growth of import prices and that this factor does attenuate the link between domestic slack and domestic consumer price index (CPI) inflation.[7] However, the role of import-price inflation further strengthens the case for a global perspective in setting monetary policies. When a country hikes its interest rate, foreign currencies depreciate against it, and to the extent that its exports are invoiced in the home currency, its trade partners’ import prices will rise. In other words, monetary tightening during a worldwide inflation surge can be a beggar-thy-neighbor policy when it effectively exports inflation to trade partners.[8] Economists identified this risk during the disinflation of the 1980s, but it is likely even more important today due to the progress of globalization since then. A further interdependence comes from the joint effect of tighter monetary policies on flexible-price goods: Witness the sharp decline in the global prices of oil and other commodities as global recession fears have taken hold.

Monetary policy coordination can reduce the pain of disinflation

In principle, central banks could avoid excessive monetary tightening without explicit coordination simply by accurate forecasting of each other’s policy moves and their global effects. Just stating this computational problem, however, illustrates how difficult it might be compared with proactive direct consultation, which at the very least would provide more transparent guidance. Moreover, joint action by central banks coupled with clear public communication could usefully moderate inflationary expectations globally. Central banks have coordinated to good effect during financial crises that raised deflationary threats, but the current inflationary conjuncture equally merits such an approach.

Don’t get me wrong. It is good that central banks have now responded to inflation through vigorous actions that telegraphed the resolve of each to regain price stability. Most advanced-economy central banks should have started doing so months earlier, thereby moderating the steep upward interest rate paths necessitated by moving too late. But there can be too much of a good thing. Now is the time for monetary policymakers to put their heads up and look around. They should take into account how the forceful actions of other central banks are likely to reduce the global inflationary forces they jointly face. Different economies will need different degrees of monetary stringency going forward. If central banks collectively pursue a gentler tightening path, however, at the same time communicating their coordinated intentions clearly to the public, they will avoid excessive sacrifices of output and employment beyond what is needed to bring inflation down.

Notes

1. Importantly, the “other things” that could shift the Phillips relationship include the inflation expectations of businesses and households, as I discuss below. For a clear and intuitive description of how central bankers rely on the Phillips curve, see the recent book by Ben Bernanke.

2. One widely cited study is by Olivier Blanchard, Eugenio Cerutti, and Lawrence H. Summers.

3. For a May 2021 argument that a flat Phillips curve could keep US inflation low during a relatively transitory period of low slack, see Laurence Ball et al.

4. Blanchard anticipated this development for the United States. With hindsight, we should not have been so surprised. The Phillips curve correlation is not a true structural relationship and its shape depends on the monetary policy regime, among other factors, as stressed by Michael McLeay and Silvana Tenreyro. Their basic argument goes back to the famous Lucas critique in the 1970s. Even before COVID-19, Joseph Gagnon and Christopher Collins suggested that the US Phillips curve is kinked, becoming steeper at very low rates of unemployment and therefore implying faster rises in inflation as unemployment falls further once it is already low.

5. Kristin Forbes discusses the hypothesis and presents additional evidence.

6. To put this into central banker jargon, if the rest of the world’s central banks are engineering “deep contraction” of their own economies, their efforts will spill over to my country, lowering the domestic neutral interest rate r* that would preserve non-inflationary full employment.

7. For example, see the papers by Forbes and Maurice Obstfeld.

8. This effect is analogous (but opposite in sign) to the export of deflation that occurs when a country depreciates its currency through monetary expansion amid a global deflationary liquidity trap.