Foreward: The Needle's Eye

The battle against Covid-19, which has to date claimed some 5 million lives, seems now to be proceeding well in advanced countries but in an uneven manner globally. However, just as every victor of a war must try to win the peace, our global fight has exposed many frailties in the international economy. Our immediate problem is that of global dislocations in aggregate demand and supply. Macroeconomic policies have rightly sought to offset the impact of stringent government lockdowns in response to the pandemic. These policies, both monetary and fiscal policies, were both massive and rapid, and they greatly tempered the loss in global income in 2020 and 2021 for those countries that were able to deploy them. However, such policies operate with both long and variable lags. The path that we must now steer involves how to remove this stimulus without risking recession or boom. The historical record suggests that it will be challenging indeed to avoid post-crisis volatility in economic performance as we try to thread many of the pieces of our normal economic life back to together into a more normal pattern. The most obvious sign of dislocation is to be found in the current worrying escalation in inflation with the US in the vanguard. While it is our view that this inflation will not lead to a damaging wage-price spiral, it remains a strong risk to our central case. The central bank playbook advises caution and gradualism in the face of shocks. However, the main risk to inflation risks solidifying is a collective failure of central banks to act. The main weakness in the central bank armoury is a direct result of the developing central bank toolkit. Quantitative easing has blurred the traditional demarcation between fiscal policies, their funding by taxes or bond issuance, and central bank policies. Not only have central banks relaxed governments' budget constraints, but also governments have responded by issuing into this extra fiscal space. The next steps in the playbook are well-rehearsed. There will first be open mouth operations about the need to secure price stability. The central banks will then signal that there will be small incremental moves in policy rates. We may also see unwinding of QE, with some tapering of purchases or the stock of QE falling in line with bond redemptions. We may then puzzle at why so little is being done with inflation rising to a multiple of its target. Further, we will ask ourselves if this lack of decisive action is because baby steps will be enough to control a very temporary price level shock or because central banks are unsure about the impact of changes in the stance of policy in such a heavily indebted and fragile world economy? In the latter case, we would have entered the world of fiscal dominance and signalled the possible end of our regime of central bank independence. This will leave households and firms with a choice when planning ahead as they will not be able rationally to bet on the former case alone. Thus, the dispersion in beliefs will undermine the attainment of continuing credibility. We have also changed some other things permanently. The monetary and demand stimuli have further escalated a secular rise in asset prices and government debt. Countries without a credible monetary and fiscal settlement risk facing sharp increases in the costs of borrowing and may now be constrained from responding to future shocks. At the same time, countries that are net suppliers of primary commodities will benefit from a sustained increase in demand as the terms of trade move in their favour. Any removal of stimulus that risks being abrupt, as we found out during 2013's Taper Tantrum, could also impose considerable negative spillovers on countries relying heavily on exports to advanced economies. The resulting increase in long term rates could ultimately be helpful in re-orienting economies away from consumption-led growth, but might also provide another sharp dislocation lying in wait for the heavily indebted because risk premia would spike. The risks are central banks tightening too little and seeing higher inflation and inflation expectations becoming entrenched, and doing too much and provoking a major asset price adjustment and consequent sharp slowdown. While we reflect this month on the need to focus on limiting climate change, we can at the same time consider what role international co-operation can play in limiting the distributional effects of changes in the policy stance. From the need to support the COVAX initiative to the new SDR allocation, we will need to think carefully about how to reconstruct the monetary and financial architecture so that more countries can deploy their monetary and fiscal tools in a manner to achieve enduring price and financial stability, which ultimately underpins global prosperity and growth. Currently, too few can, and too many may not be able to do so; we run the future risk of even fewer being in a position to do so. If increasing numbers of countries cannot commit to price and financial stability with institutions and tools, this dislocation may trigger a prolonged bout of inflation that may run out of control. The resulting inflation will wreak havoc on the world economy. It is not a risk we should take.