Speeches

Speech by Dimitris Malliaropulos, Chief Economist and Director of Economic Analysis and Research of the Bank of Greece, at ICAP 16th Conference on Credit Risk Management, titled: “Have central banks won the battle against inflation?”

15/11/2023 - Speeches

It is a great pleasure to participate in this year’s conference by ICAP and have the opportunity to share with you some thoughts on the macro challenges the world economy faces today. The times are indeed uncertain in many ways, compounding risks and policy dilemmas. Cyclical developments are interacting with profound structural changes, not least climate change and the digital transition, including transformative technologies like artificial intelligence. The continuum of unprecedented shocks that hit the global economy in the last few years has led to a long series of complex risks to manage. These risks, to name a few, relate to higher-for-longer interest rates, debt sustainability, financial stability, China’s slowdown, commodity price volatility, as well as geo-economic fragmentation and socio-political polarisation.

I decided to focus my remarks today on inflation, not only because I am a central banker, but also because I think that inflation well summarises the actual and expected outcomes of several underlying forces and distributions of risks. So far, historical regularities, the resilience of the economy and market sentiment would suggest that the fight against inflation has been won at a small cost for growth. The fact that inflation is in a declining path and a hard landing of the global economy has been avoided in the first two years of aggressive monetary policy tightening has tempted many to argue that we are out of the woods and converging back to trend.

Let me explain, in the remainder of my speech, why we must stay cautious and vigilant.

The first reason is looming risks of persistent inflation and, thus, higher-for-longer interest rates. As an ECB Executive Board member recently noted: “in about 90% of unresolved inflation episodes, inflation declined materially within the first three years after the initial shock, but then either plateaued at an elevated level or accelerated again”.[1] Inflation persistence in the short to medium term may be driven by mechanical dynamics, if base effects from volatile energy and food prices reverse from disinflationary to inflationary. Another important source of inflation persistence is indirect and second-round effects from price rigidities and the catch-up of wages to past inflation. As a result, inflation may be more persistent because downward adjustments of selling prices by firms will be smaller and less frequent and increasing unit labour costs will be only partially absorbed by shrinking profit margins. In addition, structural changes like the rising share of services in the economy that are generally labour-intensive and less sensitive to interest rates[2], as well as prolonged labour market tightness due to shortages of workers and skills could weaken monetary policy transmission and delay the disinflation process. 

Against this backdrop, it is obvious that the disinflation process critically depends on the strength and speed of monetary policy transmission to financial conditions and the real economy.  Although bank lending rates and sovereign bond yields have responded strongly to policy rate hikes, notwithstanding the lags, risk premia in equity and corporate bond markets have remained rather compressed, implying looser-than-expected financial conditions overall. Historical regularities for advanced economies and the, unseen yet, effects of quantitative tightening suggest that further tightening of financial conditions is in the pipeline. A scenario of abrupt repricing of risk assets is more likely when private debt is high, inflationary pressures are more pronounced, interest rates are high and asset valuations are stretched, like today.

Meanwhile, a set of factors have resulted in a muted transmission of monetary policy to growth.  First, real interest rates are still low by historical standards, even after their recent sharp increases, and hence, aggregate expenditure remains relatively resilient. Moreover, there is still ample liquidity in the market following the low-interest-rates era and quantitative easing; the expansion of central banks’ balance sheet has been outsized and its unwinding remains very gradual. Second, structural changes, like the higher share of fixed rate mortgages during the low-for-long era has made indebted home owners less sensitive to interest rate hikes. Companies are also less sensitive to interest rate hikes to the extent that they have issued long-term debt at a low cost during the period of low interest rates. Moreover, the increased importance of intangible assets in firms’ capital may have also weakened the response of investment to increased cost of borrowing. Third, pandemic-related distortions, such as excess savings, and buoyant labour markets have helped keep private consumption robust. In the US, for example, excess savings of households are estimated at about three trillion US dollars, i.e. about 15% of US GDP. Finally, loose fiscal policy – particularly in the US -- has bolstered aggregate demand muting the transmission of monetary policy tightening to the real economy. The gradual dissipation of these factors should bolster monetary policy effectiveness.

Looking farther out, megatrends such as deglobalisation and climate change could keep inflation elevated. The shift from offshoring to on-shoring and “friend-shoring” implies higher marginal costs for firms. In a recent corporate survey by the ECB, 60% of the respondent European multinationals confirmed that changes in their supply chains and production locations had pushed up prices over the past five years, while 45% expect such shifts to exert more inflationary pressures in the future. Meanwhile, extreme weather events and natural disasters are expected to become more frequent and disruptive, translating into negative supply shocks for the economy, while the green transition and climate adaptation policies will make conventional energy and critical inputs for producing clean energy more expensive. Carbon tax also needs to double or triple to achieve climate neutrality.[3] Needless to say that geo-economic fragmentation and trade restrictions amid strategic competition would only aggravate price pressures globally.

The second set of risks we face is fiscal risks pertaining to a less favourable snowball effect, namely higher-for-longer interest rates coupled with weaker growth. The State has become more interventionist than in the past, underpinning economic resilience in times of compounding economic shocks. However, massive fiscal support packages during recent crises have soared public debt in advanced economies near historically record levels, contributing to high inflation. Recently, the credit rating of the US was downgraded owing to worsening fiscal prospects, which implies a steepening of the US yield curve, namely an increase in the term premium demanded by investors to hold US debt. Other countries, like the UK, with a high share of inflation-linked debt are confronted with a fast rise in debt-servicing costs and nominal debt levels in an era of more persistent inflation.

Elevated debt levels coupled with higher-for-longer interest rates push government bond yields higher. Rising debt servicing costs for governments are therefore here to stay and have a lasting effect on governments’ ability to respond to crises: gross interest payments in 2024 for major advanced economies will be around 1 pp of GDP higher than in 2021. The cost of public borrowing is also set to remain high because investors may price in increased risk of debt distress ahead. Experience from past monetary tightening episodes suggests that long-term bond yields of highly indebted sovereigns tend to rise more strongly than those of less indebted ones. This reflects shifts in credit risk premia: sovereign CDS spreads tend to widen much more for high-debt sovereigns amid changes in global financial conditions, not least those that reflect a monetary tightening.

Further upward pressure on government bond yields stems from the reversal of large-scale asset purchases by major central banks during the period of quantitative easing. These purchases have been one reason why changes in long-term yields have not been sensitive to policy rate hikes in the past. As these purchases are now being reversed, the sensitivity of yields is likely to increase. The yield increases could be amplified by illiquidity in government bond markets, in particular in longer duration instruments. High levels of public borrowing, including sizeable financing needs for the green transition and infrastructure investment to cope with climate change challenges, could keep interest rates up. Financial markets might struggle to absorb both the large supply of new debt and the debt withdrawal from central bank portfolios. In this set-up, a repricing of government bonds could lead to financial market tensions. Beyond the short run and conditional on the monetary policy reaction, dampened economic activity from renewed adverse supply shocks, also in light of the recent geopolitical turmoil, could outweigh the positive impact of higher inflation on debt ratios.

Finally, we should not overlook stagflation risks. A new regime of higher inflation and lower growth remains a probability. Natural disasters due to climate change lead to destruction of physical capital stock. Companies more exposed to climate risk will see their capital depreciate at a faster pace. Climate change adaptation policies will only partially compensate for this loss of capital stock. Green investments will reduce the economic cost of climate change but there is so far no evidence that they will also boost long-term productivity growth. As a result, limited policy space, capital stock destruction and its slow replacement due to the green transition, and long periods of subdued productivity growth, among others, could depress economic potential.

In sum, the battle against inflation is not won yet. It is going to be a long and bumpy road in times of structural “shifts and breaks”, as the ECB President Christine Lagarde noted at Jackson Hole earlier this year. The last mile of disinflation is the hardest, so there is no room for complacency. Policymakers might be called upon to take bold or even radical decisions regarding the monetary and fiscal policy frameworks and tools, while international cooperation seems more needed than ever to address global challenges and macro risks.

If there is one thing characterising current times, this is uncertainty about the global growth prospects and the disinflation process, even in the absence of additional shocks. Yet, let us not forget that all times have been uncertain in history and good leadership involves understanding the risks, preparing contingency plans, hedging the bets and communicating uncertainty with confidence to steer expectations. Thank you!