Column-Central banks poised for ‘forced’ hyperactivity?: Mike Dolan By Reuters

By Mike Dolan

LONDON (Reuters) – Sudden ebbs and flows in inflation without equivalent impacts on economic output may be a feature of a post-pandemic world of fragile supply chains – which could require a stronger and more hyperactive central bank and possibly in both directions.

The speed of the increase in global inflation after the twin shocks of COVID-19 and the invasion of Ukraine was almost matched by the disinflation that followed.

So much so that central banks are now just as quickly reversing the steep and likely belated rate hikes they used to hold prices into 2022 and 2023.

The really remarkable result, despite that roller coaster, is a likely “soft landing” for economies without any major contraction in total output. And a big question for policymakers, businesses and financial markets alike is whether we’re just back to square one while dodging a rare bullet.

Trying to frame the lessons of this week’s episode, the Bank for International Settlements – the umbrella organization for global central banks – once again outlined a world where supply shocks could be more frequent and inflation more pronounced.

But in a speech in London this week, BIS deputy managing director Andrea Maechler nuanced the picture to suggest that central banks should no longer “dismiss” supply shocks as temporary irritants to inflation, as they had often done before the pandemic.

In particular, she highlighted much steeper supply curves and a steeper “Phillips curve”, which shows the relationship between unemployment and wages, or more broadly output and prices.

The gist of her argument is that such steep supply curves mean larger price movements for a given output shift, seen most dramatically as post-pandemic labor shortages have driven up wages for companies willing to ramp up business quickly.

Disruptions to overseas supplies and imports – most evident in the post-Ukraine energy price shock – have similarly meant that output growth paired with a supply shock has had much stronger effects on overall prices than before.

And crucially, the impact on economy-wide inflation was larger and faster than previous commodity and sectoral shocks in recent decades because they hit when headline inflation was already above the central bank’s target rates, it said Maechler, pointing to BRI studies illustrating this effect.

BE CAREFUL

Maechler concluded that “central banks need to be cautious when assessing the extent to which they can afford to ride through supply shocks.”

And that should inform their approach, as those supply shocks were set to become more frequent in a world of deglobalization, geopolitical tensions, a shrinking workforce, high public debt, climate change and the transition to green energy.

Being more “bold” and active in their policy response, regardless of the impact on underlying demand, was probably necessary to ensure that more volatile short-term inflation did not disrupt longer-term inflationary expectations and that confidence remained in the 2% targets.

But most intriguingly, given how wild swings in inflation and interest rates haven’t produced a major recession, Maechler said steep supply curves also mean wages and prices can fall more quickly. on target, with only relatively light hits to output from higher interest rates.

“Raising policy interest rates in response to negative supply shocks may have only limited effects on activity if Phillips curves are steep,” she said. “Then slowing the economy to tame inflation could be less costly in terms of output.”

“Today’s soft landing prospects can be partly explained by the fact that the economy – and labor markets in particular – are in a state where the Phillips curves are steeper than they were in the decades before the pandemic.”

SUBSHOOT

Where all of this fits into today’s picture is less clear, although the theme of lingering supply is clearly topical in a week of such heightened geopolitical anxiety.

Whether the steep supply curves of the post-pandemic period persist or whether most of the quirks have already been ironed out is another question.

But it would also likely suggest supply-side developments, which see inflation sharply below targets again and potentially threaten price stability on the downside, should be met similarly to central bank strength.

Just this week, European Central Bank policymaker Mario Centeno made that case clearly, while the ECB en masse appeared to be moving toward faster easing. “We now face a new risk: undershooting the inflation target, which could stifle economic growth,” he said.

Faced with falling monthly prices last month and annual inflation back below 1%, new Swiss National Bank President Martin Schlegel also said the SNB is not ruling out bringing interest rates back into negative territory.

And even recent restraints from the Bank of England have suggested they too will pick up the pace, with BoE chief Andrew Bailey saying he was “a bit more aggressive” in cutting UK interest rates.

For investors, the whole scenario points to a more volatile interest rate environment in both directions than they were used to in the pre-COVID decade.

And yet, there could remain a potentially positive horizon for earnings and the company’s stock if the broader economy can continue to navigate higher prices and borrowing rates much better than it has for decades.

The opinions expressed here are those of the author, columnist at Reuters

(By Mike Dolan; Editing by Jamie Freed)