Gita Gopinath, the first deputy managing director of the International Monetary Fund (IMF), asserts that the European Central Bank (ECB) and other central banks must maintain their commitment to curbing inflation, despite the mounting possibility of economic downturns fueled by escalating borrowing expenses.
Gopinath also highlighted the importance of anticipating future developments in the economy.
She noted that structural shifts in the economic landscape are likely to introduce additional risks to prices, which may require central banks to fine-tune their strategies accordingly.
Furthermore, she cautioned that financial strains could create tensions between the objectives of price stability and financial stability. Gopinath shared these remarks during an evening session on Monday.
“Inflation is taking too long to get back to target,” she told the ECB’s annual forum in Sintra, Portugal.
“This means that central banks, including the ECB, must remain committed to fighting inflation despite risks of weaker economic growth.”
Officials at the ECB are assessing the extent of their historic monetary tightening cycle required to bring inflation back to the target rate of 2%.
Although headline inflation has declined due to a sharp drop in energy prices, underlying pressures have proven more persistent and may have intensified in June.
In alignment with ECB President Christine Lagarde’s stance, Gita Gopinath emphasized the need for governments to contribute to the fight against inflation instead of exacerbating the situation with blanket fiscal support. By doing so, rate hikes could be concluded earlier, minimizing some of the associated consequences.
Gopinath stated, “Some side-effects of fighting inflation with monetary policy could be reduced by giving fiscal policy a bigger role.”
However, she maintained that it is ultimately the responsibility of central banks to ensure price stability regardless of the fiscal stance.
Central banks have consistently expressed their determination to fulfill this mandate. The ECB has virtually guaranteed another interest rate increase scheduled for July. Despite an impending mortgage crisis, the Bank of England remains committed to its hiking mode.
Meanwhile, the Federal Reserve in the United States, although it refrained from raising rates at its most recent meeting, is signaling a likelihood of future rate hikes.
Gopinath highlighted recent financial tensions in countries such as South Korea, the United Kingdom, and the United States, suggesting that central banks may tolerate a slightly slower return to the inflation target to avoid systemic stress. However, she emphasized that the threshold for such a decision should be high.
In addition to near-term concerns, structural factors such as global supply chain restructuring, geopolitical fragmentation, and climate change pose risks that could fuel longer-term inflation. Consequently, a return to the ultra-low interest rates observed prior to the pandemic becomes less probable.
Gopinath asserted that central banks may need to adopt a more aggressive approach if supply shocks are widespread and affect critical sectors or if inflation has already surpassed the target, leading to potential disruptions in expectations.
Moreover, in a robust economy where producers can readily pass on cost increases and workers are less inclined to accept real wage reductions, central banks may need to respond more forcefully.
The efficacy of quantitative easing (QE) and its associated costs and benefits may also necessitate reevaluation.
While acknowledging its importance as a “critical tool” during periods of high unemployment and low inflation when borrowing costs are near their minimum, Gopinath urged caution when employing QE and pairing it with forward guidance that promises prolonged low policy rates in situations where employment has largely recovered and inflation remains only moderately below the target.
Maintaining QE under such circumstances raises the risk of the economy overheating and necessitating a sudden policy reversal.
It’s clear central banks, including the ECB, must navigate the delicate balancing act of taming inflation while considering the broader economic landscape, potential risks, and structural shifts.
The role of fiscal policy and the consequences of monetary tools like interest rate hikes and quantitative easing will play crucial roles in achieving price stability and sustaining economic growth.