Holding the Line: The Right Response to War and Covid

Shocks persist. They are rarely the one-off simple impulse beloved by academic economists. Indeed, they often combine in strange and unpredictable ways. So, while international focus has fallen rightly on the myriad issues raised by the Russian invasion of Ukraine, we must also remember that we continue to live in the shadow of Covid.

The World Health Organization has published an estimate that suggests show that the death toll associated directly or indirectly with the Covid-19 pandemic (described as “excess mortality”) between January 2020 and December 2021 was in the range of 13.3 million to 16.6 million. To put this in context, it is around a third to a quarter of the death toll from World War II in around a third of the time.

As such, Covid has represented a huge disruptive experience that has tested monetary and fiscal frameworks, the quality of our health provision and asked hard questions of globalisation. But when we throw in an invasion that has further asked us about our common defence frameworks and food and energy security. As the problems mount, central banks will have to hold a fine line between nurturing a return to normality but also ensuring that the prize of price stability is not lost. Given recent economic history it is hard to imagine that further crises do not lie in wait.

Of course, the global surge in inflation has its origin in the stoking of demand by monetary and fiscal authorities around the world to help stabilise activity during the Covid-19 lockdowns. Such interventions were required, and mostly lauded, as governments were providing an insurance payoff to households that were not responsible for the pandemic. But these monetary-fiscal impulses were open-ended rather than being explicitly constrained by the Covid cloud.

This meant that forward-looking agents did not necessarily think that loose monetary and fiscal policies would be tied to a Covid intervention alone, indeed there were no contemporaneous statements as to how this excess liquidity was going to be drained once we approached normality. This liquidity fed into asset and commodity prices. And as we approached the end of restrictions on our day-to-day freedoms, we faced supply chain disruptions, which acted to raise prices further. The general price level was then ratcheted up by surging prices in world food and energy markets, because of the Russian invasion of Ukraine.

If anything, there has been the appearance of some complacency as we debated whether the inflation shock was temporary or permanent, and possibly seemed to forget that it is the monetary authorities who always determine which one of those outcomes come to pass.

In the language of economists, not only did the Phillips curve, which is the relationship between inflation and the balance of demand and supply, get steeper but it also shifted inward, which meant that a given level of excess demand – created by monetary and fiscal interventions – was considerably more inflationary that it might otherwise have been. This heightening in inflationary pressure has placed more urgency on the central bank response.

Worryingly, that may not be the end of the wandering Phillips curve. We may also find that when we add the impact of economic sanctions on Russia, and a structural slowdown in China, the momentum for global growth post-Covid may be about to stall.

The whole train of events may eventually lead to a major global contraction, or recession. This is, in part, because policy rates will have to rise significantly to contain the inflationary shock. This is important because having won with such difficulty the prize of price stability during the past quarter of a century, we cannot afford to allow it to fall out of our grasp.

But it will be no easy matter to calibrate the correct response alongside an exit from quantitative easing (QE) without triggering financial market disruption and a sharp fall in activity. Fiscal policies can, of course, help smooth the income shock, and this would have the added benefit of giving more latitude for a monetary tightening. But unfortunately, in many countries, orthodox measures of fiscal space look exhausted and policy-makers seem wary of adding to public debt once again, which has been elevated twice over: once since the global financial crisis and then again following Covid.

It is fortunate that some countries – such as Germany – have the fiscal space to lessen the shock of war. But it not clear that it will used. It almost seems as though fiscal policy-makers have forgotten their role to support income in the face of temporary shocks and to limit the distributional consequences of those shocks. Perhaps we should not have expected the re-engagement of the global economy after Covid to be smooth. But the current juxtaposition of shocks and fiscal ambivalence may pose more than just a headache for central banks.

But for central banks the way is actually reasonably clear. There is a need to restate a commitment to price and financial stability. That means rebuilding the consensus across society by pointing towards the evidence of what happens when we fail in this respect – and, unfortunately, we have a new evidence base.

Any experiments with inflation averaging should be dropped, as no central bank will want to offset today’s price level overshoot by generating a deflationary recession in a year or two. Bygones really are bygones. To support the credibility of the commitment, we need to see clear statements on the path and targets for the stock of QE, which in steady state will be a much smaller fraction of what we currently have.

Central banks need to work through the development of scenarios under which policy rates can return to normal levels and not hover around zero. The unfortunate example of Japan looms: policy rates at zero and public debt have escalated and combined to limit economic progress. Let’s use this crisis to get back to the monetary norm.

This article first appeared in Central Banking on 9 June 2022 and is reproduced here with their kind permission