IMF warns Central Banks of “Uncomfortable Truth” in Inflation Fight

The deputy director of the IMF warned that central banks may need to accept the “uncomfortable fact” that inflation could continue to rise above their 2% target for a longer time in order to avoid a financial crises.

Gita Gopiath said at the European Central Bank annual conference in Sintra (Portugal) that policymakers could be faced with a difficult choice between solving an upcoming financial crash in heavily indebted nations and raising borrowing rates enough to curb stubborn inflation.

Gopinath stated before her speech that “we are not yet there, but it is a possible scenario.” In that environment, you might see central banks adjust their reaction function to say ‘OK maybe we can tolerate higher inflation for a little longer’.

Gopinath said that the high debt levels of some European governments makes them vulnerable to a new financial crisis. He was promoted last year from his position as chief economist at the IMF to its deputy managing Director.

Gopinath stated, “We’re entering a phase where we must acknowledge that it is taking far too long for inflation to reach the target. That is my first uncomfortable reality. We risk having inflation entrenched.”

In her speech, she stated that “when governments lack fiscal room or political support to address the problem, they may need to adjust monetary policy to take into account financial stress.”

She said there should be “a high bar” before central banks allow inflation to remain above their 2% target for a longer period of time, because this could cause price increases to become even more entrenched as they did in the US during the 1960s.

She said that financial stress in the Eurozone could have diverse regional effects. “[Interest rate] spreads may rise more in certain high-debt countries”, and it could “amplify” other vulnerabilities due to household debt and a high share of variable-rate loans in some countries.

Gopinath stated in her speech that ECB and central banks should “be prepared to respond forcefully” if signs of persistent inflation persist, even if this leads to a “much greater cooling” on the labour market.

The ECB raised its benchmark rate to 3.5 percent earlier this month, a pace unprecedented in the past.

She said that governments could also fight inflation by reducing the deficit-financed spending in order to reduce demand and lower the amount the ECB would need to increase rates by.

She said that “given the current economic conditions, due to high inflation and record-high debt levels, both would call for a tightening fiscal policy.” If you look at the projected fiscal deficits of many G7 nations, they are too high and for too long.

The ECB created a programme to buy bonds, known as the Transmission Protection Instrument. It was designed to prevent rising borrowing costs from triggering a new sovereign debt crisis in the eurozone. Gopinath says that this program has not been tested and more can be done to prepare the eurozone for possible financial stress.

She called on EU leaders to adopt new rules to reduce their budget deficits, as well as debt levels that have reached 100 percent of the gross domestic product (GDP) in several countries, including France and Italy. Also, she urged them to implement a single deposit-insurance scheme for all banks of the eurozone to replace a patchwork of different national systems.

The US government has provided additional deposits guarantees in order to ease the banking crisis that was sparked in the US by the collapse in March of Silicon Valley Bank.

You could be in a situation where you need fiscal assistance, but it’s not politically feasible. If you’re dealing with nonbanks, it can be very difficult.