About the author: Nick Stadtmiller is an emerging markets strategist at Medley Advisors.
Central bankers face a difficult choice. How hard are they willing to slam the brakes on growth to slow down inflation? Policymakers may find they are unable to bring price pressures under control without forcing their import into recession. For emerging markets this quandary appears especially difficult.
Some central banks are already hinting that they will need to kill growth to restore price stability. Banco Central de Chile sees inflation peaking later this year before falling in 2023. Annual consumer price growth in Chile is over 11%, way above the central bank’s 3% target. Chile’s central bank has already raised its policy rate by 850 basis points in the past year, and it projects it will likely increase rates further this year. It also expects Chile’s economy to contract in 2023. This suggests the monetary authorities are willing to drag the economy into recession to slow an overheating economy and reduce inflation to target.
The example of Chile is telling because its central bank has been ahead of the curve in this cycle, raising rates earlier and more aggressively than many of its peers in response to surging inflation. Chile’s central bank may also lead the way in predicting that rapid tightening to slow inflation will also lead to economic contraction.
Like Chile, most central banks have an inflation target as their sole or main objective. But even a central bank that exclusively targets inflation tries to avoid unnecessary economic volatility in achieving its goal.
Textbook models suggest a central bank should set monetary policy to keep inflation as close to target as possible while preventing the economy from overheating or from falling too far below an equilibrium level of output. This sounds easy in theory: Officials can plug various paths for the policy rate into their economic model and choose the trajectory that gradually increases inflation back to target with the least disruption to growth. In practice, setting monetary policy is an exercise fraught with uncertainty.
One difficulty is that no one really knows the equilibrium level of activity consistent with low and stable inflation (economists call this potential output). It is very difficult to estimate in real time the Goldilocks level of employment and output that is neither too hot (which stimulates price pressures) nor too cold (leading to weak growth and high unemployment).
Adding to this challenge, there have been several structural transformations in the wake of the Covid pandemic, including supply-chain bottlenecks and reshoring of production lines. These changes have likely reduced potential output in many, but no one is sure by how much or how long these distortions will last.
Another problem is that inflation and growth may respond differently to tighter monetary policy. Over the medium term, inflation should be close to target when the economy is at potential output. But in the-term, it may require rapid short rate increases to get inflation down to the desired level, leading to a sharp slowdown in growth or a contraction.
Inflation is partly influenced by the gap between actual and potential output, but expectations are also important. Central banks are especially concerned because the recent inflation spike has boosted expectations for future price increases. Anticipated inflation can become a self-fulfilling prophecy, leading to further price rises in part because everyone behaves as if high inflation will persist. Once inflation expectations creep up, policymakers must act even more aggressively to tamp them down.
The difficulty of stabilizing inflation without killing growth attracted little attention in the prior decade because global inflationary pressures were benign, in part due to expanding globalization. Moderate inflation prior to the pandemic meant few central banks had to resort to rapid rate increases.
Traditional rules of thumb for estimating appropriate monetary policy are of limited use today. These policy prescriptions assume potential output is known and inflation expectations are well-anchored—dubious propositions in the current environment.
Central bankers have only one reasonable strategy available: raise rates until they see inflation readings fall convincingly. The catch is that monetary policy works with a lag. By the time inflation slows, officials will realize they have tightened policy too much.
Monetary officials in emerging markets face two additional difficulties. First, emerging-market tend to “import” financial conditions from the United States. The dollar’s outsized role in global trade and finance transmits US monetary policy into other exports. Governments and businesses in emerging markets conduct many international transactions in dollars, including borrowing. Tighter policy in the US means lower liquidity and higher interest costs for dollar credit in emerging markets.
Central bankers in emerging markets do not know how much the Federal Reserve will tighten policy. They can only make assumptions about the Fed’s likely path when formulating their own policy. This creates a risk that local conditions end up too tight if the Fed raises rates by more than local policy makers anticipate.
The second challenge is the impact of rising commodities prices. Food and energy prices have increased substantially this year, in a large part due to Russia’s invasion of Ukraine. Higher commodities prices push up inflation and tend to be a drag on activity for commodity-importing countries, since they increase the import bill and crowd out spending on other goods and services. The effect is compounded in emerging, where consumers spend a greater share of their incomes on food and energy than their counterparts in wealthier countries. In responding to a commodity-price shock, central bankers face a conflict between tightening policy to counter rising inflation and easing to cushion the economy.
In the face of uncertainty, most central banks are likely to err on the side of bringing inflation under control, sacrificing growth in the process. Most central banks are politically independent, but no monetary authority wants to attract the ire of elected officials for deliberately causing a contraction in activity. That means policy makers are unlikely to admit they consciously made such a choice. But the economics are stark: For many emerging crises, dealing with the inflation may require engineering a recession.
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