Foreword: Troubled Waters

This Autumn, there is much focus on the normalisation of interest rates after half a generation bumping along the bottom. The Federal Reserve, the ECB and the Bank of England have all moved policy rates back into more familiar territory with consequently 10-year bond rates, as I write, now at 4.2 per cent, 2.3 per cent and 3.6 per cent respectively. Although the overall direction of travel is very welcome, the transition will throw up points of tension in financial markets. It is, in effect, a regime change. And we have learnt from years of observation that at such times the path of policy rates "never did run smooth". In this case central banks are faced with picking a path for policy rates in the middle of an inflation surge, a war, a seemingly insoluble lump of public debt, a global tightening cycle and at the start of quantitative tightening. It is an unenviable job. The UK managed to encapsulate many of the possible problems with its ill-conceived mini-Budget and provided a good case study for IMF pedagogues on how not to do it: specifically ensure that monetary and fiscal policies are not aiming for different targets and do not disregard the advice of experts on the path of public deficits because credibility gives you more flexibility not less. To the extent that orthodox advice is now more likely to be universally adhered to, we are probably more in danger of running a set of monetary and fiscal policies that are too tight than too loose. This risk is amplified because no one set of policy makers want to emerge from the pack, to be picked off by the bond market. Using NiGEM, we examine the impact on global GDP of a US-led tightening and one where countries move more in unison to a common shock. In the former case, if the Federal Reserve starts to raise rates and the rest of the world follows when their exchange rates fall, the deflationary shock to world GDP is a little over 1 per cent. On the other hand, if we think of a global shock to which all countries respond in concert, the overall deflationary effect is likely to lie around 3 per cent. The right answer depends on what shock we are currently facing. And there are two. The first is the need to reverse extraordinary supportive monetary and fiscal policies - remove stimuli - and the second is to ensure that the increase in energy and food prices do not lead to persistence in inflation and an ongoing loss of monetary value - deal with second round effects. An energy price shock tends to reduce global activity, if it arises from a disruption to supply, and leads to a temporary inflation providing the nominal anchor holds firm. It means that consumers and producers must condition their plans on higher prices for a key ingredient of activity and this tends to lead to a reduction in activity and some substitution away from energy intensive forms of production. While the increase in energy prices boosts the real income of net producers of energy it also reduces the real income of net consumers and when we add in the consequences of a war, bringing with it further uncertainty and delay in the repair of supply chains, the net effect is to undermine global growth prospects. For example, we now expect global GDP growth next year to fall from 2.8 to 2.5 per cent, inflation to rise from 6.2 per cent to 7.3 per cent and for world trade growth to fall from 2.8 per cent to 0.5 per cent. Ideally given this shock there would be a gradual move to higher rates, which would allow central banks to understand the impact on heavily indebted economies and ensure that collective policy across the advanced economies does not provide too strong a deflationary impulse. We think that more moves towards transparency on the path of rates consistent with attaining price stability a bit further down the line, for example in 2024, would be very helpful at this time as it may help market participants contain their policy rate expectations and help ensure a softer landing for economies, in part by avoiding an information cascade driving rates to unnecessarily high levels. If we can avoid the extreme levels which some market commentators think rates have to obtain, it would act to leave some fiscal space being available to economies scarred by Covid-19 and War.