Central banks have done their part, now others need to step in

Central banks have shown they can take decisive action to prevent the most drastic rise in inflation in a generation. They have taken steps to protect the purchasing power of people and businesses. Although the final mile back to price stability is not yet complete, the end is in sight.

Inflation hurts those who are least able to protect themselves against it. Intervention was necessary to deal with what seemed an inexorable rise in the cost of living. To restore price stability, central banks unleashed the largest and most synchronised tightening of global monetary policy in decades.

This episode demonstrated the value of having independent institutions outside the political process as guardians of price stability. Their ability to act at a distance from governments helps central banks make decisions that may be distasteful and politically unpopular in the interests of fighting inflation.

Of course, circumstances helped. Rebuilding trade logistics and falling commodity prices supported disinflation. But we saw in the 1970s how a rapid rise in inflation, if unchecked, could trigger a shift toward high inflation. By acting with determination, in line with their mandates, central banks prevented high inflation from becoming permanent. Without swift and decisive central bank action, restoring price stability could have seriously damaged growth and employment.

Now is not the time to let down our guard. Inflation is lower, but not low enough in some places. Surprises can come in the final minutes of any match. Compared to other prices, services costs and net wages lag behind pre-pandemic trends, and a rapid catch-up could put renewed upward pressure on inflation. Central banks must stay the course.

The post-pandemic surge in inflation was just the latest in a series of tests of central bank policies. In our latest Annual Economic Report, we at the Bank for International Settlements look at the turbulent period since the turn of this century, including major financial crises and the unprecedented experiment of turning the global economy on and off due to the pandemic.

We reflect on the lessons learned and the implications for the future. Above all, our analysis suggests that a key lesson from the past quarter-century is the need to recognize what monetary policy can and cannot do.

This period showed the power of monetary policy. It showed that central bank emergency action, using its firepower to ensure a steady flow of liquidity, can stabilize the financial system, support the flow of credit to businesses and households, and prevent the economy from sliding into collapse. We have learned that central banks are important players when it comes to financial and price stability.

But we also learned that monetary policy cannot fine-tune inflation. It is important for central banks to act when inflation is above normal. However, such measures are less justified and may even be counterproductive when inflation is a few fractions of a percent below the central bank’s targets. Inflation targets should be a guideline, not an obsession.

Extremely strong and long-lasting monetary easing aimed at stimulating too low inflation becomes less effective the longer it lasts and may generate undesirable side effects. These include the build-up of debt, now at historic highs, and distortions of markets and investments. It also limits central banks’ policy room for maneuver, making it more difficult to exit stimulus measures and untangle central bank and government policy.

Policies work better as part of a coherent whole. Even now, as central banks continue to try to keep inflation under control, we see that around the world, fiscal donations made during the pandemic may be counterproductive, stimulating the economy and stoking inflation.

The final lesson is that central banks alone cannot deliver sustainable economic growth and prosperity. Laying the foundations for a brighter economic future requires action from other policymakers, especially governments.

To reap long-term benefits, governments must act with urgency to put budgets on solid footing and prepare economies for the future. They must limit the growth of public debt and accept that interest rates may not return to the very low pre-pandemic levels. The ability to service debt is crucial for both price and financial stability, as well as maintaining a constant value of the currency.

In the long term, structural reforms are key to sustainably raising living standards, improving economic prosperity and providing people with a sense of security. This means taking lasting measures such as promoting competition, increasing flexibility and boosting innovation. Scarce public funds should support the economy’s adaptation to new realities such as climate change and technological change, including the revolution of artificial intelligence. Only a solid foundation allows us to build for the future.