Central Banks Facing Global Challenges

“The end of history” is canceled

The monetary history of the past few decades has seen periods of both ascent and decline of the authority of central banks. The ability to tame inflation in the 1990s became widespread. By the time of the global financial crisis in 2008, it seemed that central banks had reached the “end of history”: independence which they gained was well-institutionalized; price stability was no longer compromised for sustaining robust economic growth; exchange rate flexibility ceased to be a “stumbling block” in international discussions and domestic political debates; interest rates became a “magical” instrument for maintaining macroeconomic stability.

However, the global financial crisis and subsequent events demonstrated that hopes for the “end of history” were illusory. Instead, rapid adaptation to the new environment is necessary. Characteristics of this environment include entrenched risks of inflation expectations falling below target, declining productivity and movement of neutral interest rates into red, increasing debt levels in both private and public sectors, growing role of financial factors in macroeconomic instability etc. The era of unconventional monetary policy reached its peak during handling the consequences of the COVID-19 crisis. During this time, even countries for which asset purchases by central banks, near-zero or negative interest rates, and increasing countercyclical budget deficits were unthinkable just a few years ago pursued macroeconomic expansion. Meanwhile, the redistributive consequences of unconventional policies in favor of asset owners and exaggerated expectations of central banks’ ability to solve all economic problems through rate cuts and money printing have generated a wave of populist attacks on monetary institutions.

The global inflation surge of 2021-2023, if not extinguishing the flames of populism, has at least slowed its spread. However, clear misinterpretations of the nature of the post-COVID inflation shock placed central banks on the brink of losing trust. Moreover, the war waged by Moscovia against Ukraine has shaken the global economy and world order to such an extent that we can speak of the emergence of a new global environment for central banks. Apart from geopolitical tensions and further geo-economic fragmentation, this environment will be characterized by increased volatility and poorly forecasted supply shocks. This will require central banks to exert additional efforts to support price stability and rethink the nature of risks to macro-financial stability.

The specific context of 2021-2023

The understanding of key features of the new central bank environment is based on changes shaped by the contradictions following the global financial crisis and intensified by the aftermath of overcoming the COVID-19 shock. Abnormally high inflation worldwide and high correlation of inflation surges in many countries will continue to define macroeconomic trajectories in the global economy for a long time. Interest rates will remain significantly higher for an extended period compared to the 2010s (see Figure 1). However, there may be other scenarios, as the operating environment for central banks has changed significantly.

First, even before the COVID-19 shock, central banks were facing growing populist pressure. This phenomenon became truly global. In different continents, formerly successful and respected monetary institutions found themselves under unexpected scrutiny. The implementation of "unconventional" monetary policies (quantitative easing or direct asset purchases by central banks) had an undesirable redistributive effect (enriching asset owners) that policymakers easily juggled. Positive impact of such policies on labor markets and employment was only noticeable in complex econometric models. The government and corporate debt increase created a political-economic environment tolerating low interest rates.

This had implications for central banks. Without formal changes to mandates and procedures in implementing monetary regimes of price stability, policy became relatively loose. The political-economic selection of candidates with "dovish" preferences (i.e., a tendency to keep rates low to stimulate the economy) for leadership positions in central banks gradually revealed itself. Therefore, the lenient response of many regulators to the 2021 inflation shock reflected a new political-economic and, to some extent, academic consensus on the additional flexibility of monetary policy (greater tolerance to deviations of inflation from the target). Subsequent actions by central banks have shown that this idea is erroneous and their independence matters. Political sentiment can quickly turn against inflation, so steadfastly adhering to the mandate of price stability is the best alternative for all time horizons. 

Second, the years 2020-2021 became a period of reconsideration of monetary strategies by the Federal Reserve, the European Central Bank, and the Bank of Canada. They sparked discussions about central bank mandates in Canada, New Zealand, and elsewhere. After the global financial crisis, some scholars and central bankers discussed the need to either raise the inflation target or allow inflation to stay above the target for a while to prevent anchoring inflation expectations below the target. The review of strategies by leading central banks indicated their appetite for a more flexible monetary policy. It would rely on an interpretation of price stability that does not contradict above-the-target inflation. According to them, this would create better adaptation to deflationary biases of inflation expectations and lower neutral rates. The inflation surge quickly became interpreted as a stress test for the viability of new strategies. Finally, the rapid (albeit late) rate hikes in the global economy (see Figure 1) blurred the line between implementing new, more flexible monetary strategies and persistently fighting inflation.

Third, the full-scale war initiated by Moscovia against Ukraine intensified the global supply shock. However, the increase in energy prices began earlier - in the second half of 2021 - due to Russia's artificial restriction of gas supplies. This situation, along with restrictions on grain supplies to the global market, is an example of the geopolitical engineering of supply shocks. Russia and other autocracies will likely continue to use this tool to influence the political agenda in many countries. After all, rising prices and the corresponding increase in interest rates to combat inflation are more likely to cause dissatisfaction with the current government's policy than a willingness to confront the true culprit behind the price increase.

Clearly, central banks are not directly responsible for such acts of geopolitical vandalism. However, the timely response of monetary authorities to the global rise in commodity prices mitigates the impact of these prices on inflation. Therefore, it is important how central banks interpret the drivers of inflationary pressure and communicate the links between policy decisions and price surges.

Global instability and supply-side pressure: A new reality for central banks?

Global integration has reached a level where even minor disruptions in supply chains, trade flows, and capital movements affect a significant number of countries. The experience of globalization waves reveals high sensitivity of global macroeconomic stability and the progress of global integration to geopolitical factors. It is no coincidence that the higher the geopolitical risks, the more they are associated with uncertainty in economic policy. Today, the geopolitical impact of commodity prices (especially energy prices) has decreased compared to the situation 50-60 years ago (the United States has become an energy exporter, their dependence on oil imports has eased, most developed countries have significantly reduced energy intensity of GDP, etc.). However, at the same time, the importance of global value chains and trade in intermediate goods has increased. Creating a unit of global GDP has become more dependent on logistics, trade route security, and the import of critical technological components.

Geopolitical tensions, aggressive actions by individual players, and subsequent adaptive reactions generate processes of increased volatility that are poorly forecasted. They affect the strong side of central banks - their competitive advantage in macroeconomic modeling and their ability to make decisions supported by models. Overall, this will contribute to a significant increase in uncertainty. Most likely, changes will occur in the global economy that will reduce its flexibility. The rise in geopolitical risks will be accompanied by an activation of inflationary factors on the supply side and an increase in the level of uncertainty in economic policy.

In order to empirically confirm structural changes on the supply side, we consider the Geopolitical Risk Index,  Commodity Price Index, Global Supply Chain Pressure Index, and Economic Policy Uncertainty Index. For each of these indices, we calculate the mean (level indicator) and standard deviation (volatility indicator) for three periods: 1998-2008 (from the Asian to the global financial crisis); 2009-2019 (from the global financial to the COVID-19 crisis); from 2020 to the present (COVID-19 crisis, overcoming its consequences and inflationary surge, geopolitical tensions, Moscovia's war against Ukraine, and geo-economic fragmentation). The results are presented in Figures 2-5.

Figures 2-5 clearly show an upward trend of means and standard deviations of the considered indices. The respective values for the third period are higher than those in the first period (except for the Geopolitical Risk Index). Geopolitical tensions slightly decreased in the second period but worsened in the third one. Volatility in commodity prices fell slightly in the second period, but the mean continued to rise steadily. Pressure in supply chains and uncertainty about economic policy demonstrate some deterioration in the second period and significant worsening in the third one. 

Supply-side shocks pose a challenge to central banks primarily because they limit the ability of monetary policy to ensure price stability without provoking uncertainty about GDP reaction. They also worsen the trade-offs for policymakers, making central bank responses to shocks less predictable for markets and more influenced by preferences and political expediency. 

Why will the work of central bankers become more challenging?

Structural changes in the global economy will complicate maintaining price stability.

Until recently, the belief that globalization is disinflationary dominated. In the globalization environment, structural factors that slowed down or even reduced inflation (trade integration, competitive pressure, structural reforms, etc.) were at play. This made it possible to maintain relatively lower interest rates per unit of inflationary pressure. The inflationary surge of 2021-2023 and subsequent processes suggest that the global economy can be a source of inflation. Convergence of wages in China with those in developed countries, slower trade integration, increasing dependence on reliable supply chains, unpredictable behavior of transportation costs, along with the long-term trend of rising commodity prices suggest that the "disinflationary bonus" of globalization, if not entirely a thing of the past, will undoubtedly be lower than in previous decades. 

The inverse relationship between inflation and unemployment (the Phillips curve) has evolved during globalization. In the 1990s the consensus was that economic openness limits the effectiveness of inflationary incentives to increase employment (a steeper Phillips curve). In the 2000s, there was considerable evidence suggesting that inflation was insensitive to changes in labor markets (the flatter Phillips curve). The transformation of supply chains and the relocation of foreign direct investment on a global scale are likely to return the world to a situation of moderate openness but lower integration. In other words, the space for flexible responses to supply shocks will narrow. Monetary policy will need to be harder in order to avoid simultaneous deterioration in both inflation and employment. Therefore, initiatives to implement more flexible monetary strategies in developed countries will need to be reconsidered.

More uncertainty and lower usefulness of models?

Increased volatility significantly complicates the ability to make optimal decisions, especially when volatility relates to parameters outside of direct control of individual central banks.

The years 2021-2022 demonstrated that forecasting models of most central banks suggested a soft monetary response at the onset of the inflation surge. Such a response would have been justified under normal circumstances: during a supply shock, an increase in production levels can be expected, making it desirable to keep interest rates low. However, under significant uncertainty and producers' lack of confidence in their investment prospects, predictive power of models may decrease. Consequently, central banks will rely less on forecasts offered by models and give more weight to their own expert judgment. Of course, central banks have a certain stock of trust. However, they will need to emphasize changes in the global environment that affect monetary decisions. 

During times of geopolitical tension, governments of many developed and emerging market countries have significant accumulated debts. Substantial budget deficits were a problem already during the low-interest rate period. However, with rising interest rates, fiscal policy may become a source of macroeconomic risks. The fiscal space will narrow at the very moment when democracies need additional security funding. At the same time, military expenditures, while fueling production through multipliers, will, in the long run, reduce the ability of fiscal policy to positively impact increase in total factor productivity. With a narrowed fiscal policy space and rising debt servicing costs, central banks may face a new round of political and populist pressure. To prevent the increase in trade-off between inflation and GDP, central banks will need to emphasize the importance of structural reforms and better tax collection in their communication to support price stability.

The ongoing discussions over the fate of the frozen Russian central bank assets for the past two years show that the global monetary system is becoming an arena of geopolitical rivalry. Regardless of whether the confiscation of Moscovia's sovereign assets occurs or not, the world will face a new round of competition for reserve assets. The quest for new technological solutions in international settlements will increasingly become an extension of geopolitical competition. The increase in the share of non-traditional currencies in capital flows and currency reserves is unlikely to enhance global macro-financial stability. The liquidity of reserves is of fundamental importance. Therefore, the deterioration of the situation with currency exchange rates and capital flows due to lower liquidity of global currency reserves will further undermine the resilience of the global economy.

Conclusions

Throughout the course of globalization, central banks have experienced periods of tranquility regarding the effectiveness of monetary policy, as well as complex crises, challenges, and populist pressures. Post-COVID inflation, geopolitical tensions, and potential global defragmentation worsen the structural environment of monetary policy. Supply shocks may become a long-term factor deteriorating central banks' ability to maintain inflation close to target levels with interest rates levels familiar to political and economic actors in recent times. It is possible that more flexible monetary policy strategies will require a reconsideration. Central bank communications must increasingly focus on explaining structural changes in the global environment, where supply-side price pressure should not undermine trust in central banks' ability to fulfill their price stability mandate.