Kevin Lynch is former vice-chair of BMO and former clerk of the Privy Council. Paul Deegan is chief executive of Deegan Public Strategies and former deputy executive director of the National Economic Council at the White House.
When finance ministers and central bank governors gathered in Washington this past week for their regular International Monetary Fund-World Bank policy conclave, they must have been thinking what a difference six months makes: a war in Europe, the war against inflation, a “no-limits” strategic partnership between China and Russia, and continuing disruptions in global supply chains.
Central bankers seemingly placed too much confidence in their models and their forecasts, and they missed the biggest surge in inflation in four decades. Too much demand chasing too little supply is inherently inflationary regardless of the nobility of the policy objective.
The new British Prime Minister strangely lost sight of fiscal and political reality, and quickly consigned Trussonomics to the dustbin of history. The “debt-doesn’t-matter” choir, which has been playing to rapt government audiences in the U.S., Britain and Canada, among others, has lost its voice in the face of soaring interest rates and mountains of public and private debt.
Inflation is now the number one policy issue facing politicians, policy makers and individual citizens.
The world will need supportive not contradictory fiscal policies to minimize the economic costs of reducing inflation. Yet today there is an increasing mismatch between the monetary policy of central bankers and the fiscal policy of finance ministers, making the IMF-World Bank gathering almost a curious meeting of opposites. This will lead us down a very dangerous path if it is not arrested.
The known unknowns of inflation fighting are straightforward: how high interest rates will have to go to break the inflationary spiral and whether a recession is inevitable to achieve central bankers’ goal of low and stable inflation again.
Too slow off the mark, the Fed had been adamant it would defeat inflation and do whatever it takes to accomplish this. Here in Canada, the central bank was equally slow in reading the inflationary tea leaves but, like the Fed, it is rightly raising interest rates aggressively and sounding a clarion call to wrestle inflation back into its target range.
Tight labour markets and ever-higher levels of government spending, and the increase it brings to fiscal deficits, will only add to demand and push central banks to raise interest rates even higher. Today, stagflation is a real risk, and the world is starting to feel like the 1970s again. Cheap money, supply chain disruptions and low growth were hallmarks then and now.
To get us out of this morass, fiscal measures should be highly targeted to those most affected by inflation and be fiscally neutral. Additionally, governments should be careful about their wage settlements and the impacts that large, multiyear wage agreements can have on inflation expectations and private-sector wage pressures. Unfortunately, governments appear to be leaving the inflation fight solely to their central banks, which heightens the stagflation risk.
Worse, many governments are spending and raising their deficits. The Biden administration has introduced new multiyear spending.
The British government appears to believe that massive stimulus is the best way to deal with inflation. In rebuking that last week, IMF managing director Kristalina Georgieva stressed that her remarks were “our message to everybody, not just the U.K.”
Germany is signalling that it will spend whatever it takes to get through the energy crunch. The IMF strongly advocates for greater consistency in the mix of monetary and fiscal policies in the fight to quell inflation before inflation and inflation expectations become entrenched in price and wage setting.
In its just released World Economic Outlook, the IMF believes “more than a third of the global economy will contract this year or next, while the three largest economies – the United States, the European Union and China – will continue to stall.” But importantly, despite these anticipated contractions, the IMF still forecasts annual growth in 2023 of 1 per cent for the U.S. and 1.5 per cent for Canada, and it does not believe a large downturn is inevitable.
One thing that is certain is that currency and financial markets, and housing markets, are in for a period of volatility. It is less about inflation and more about what central banks will no longer be doing: The era of ultralow interest rates and quantitative easing is over, and the hangover will hurt. And, with the Fed leading the charge to raise interest rates, the U.S. dollar has soared – putting pressure on many emerging markets’ ability to finance their debt and introducing further risk in debt markets.
Surveying this tumultuous global environment, the IMF observed that “as storm clouds gather, policy makers need to keep a steady hand.”
In practice, this means defeating inflation, and having monetary and fiscal policies that are aligned – not contradictory.