The long and short of it: Central Banking case studies in point – Central Banking

Central Banking’s case studies around current challenges for developed and emerging market central banks – high inflation, monetary policy responses and central bank balance sheets – cover all bases. Responses span diverging macro/financial experiences and policy responses to shared economic shocks. Diversity within a wide confluence of higher inflation, tighter monetary policies and shrinking balance sheets is critical for policy-makers, market participants, reserve managers and private market participants.

From lowflation to highflation amid differentiation

• Supply-side inflation

Within a near-global inflation surge lies a gamut of inflation experiences. This ‘highflation’ is not yet for the history books – it is still unfolding. The economic experience of recent years suggests supply-side inflation has made a comeback via repeated, unprecedented and unexpected commodity and terms‑of-trade shocks, spurred by the Covid-19 pandemic and the Russia-Ukraine war.

Supply-side highflation probably originated in spending shifts from services to goods during lockdowns, and back to services on reopening, plus shifts in labour markets. Initially, goods supply chains were disrupted before firms and countries – notably China – found ways to enforce lockdowns while keeping factories running.

Professional services – such as law, finance, many aspects of business and even medicine – also continued in a virtual or hybrid manner. But face-to-face services – including tourism, leisure, hospitality and many household services – could not, and bore the brunt of lockdown policies.

Reopening substantially reversed this, with demand for services and experiences surging and switching from an oversaturated demand for goods. Yet supply factors aggravated these outsized shifts in demand and spending patterns. Labour markets became very tight because of pandemic-related early exits through retirement, changes in preferences for types of work, fatalities and cases of long Covid.

Then along came another type of ‘imported inflation’ – a terms-of-trade shock triggered by Russia’s invasion of Ukraine. The two countries normally together account for vanishingly small shares of global growth, activity or price formation. Yet they have disproportionate effects on many crucial components of global supply chains. From basic primary commodities – oil, gas and soft commodities such as food grain – to specific components in the auto supply chain for which there were few immediate alternatives.

The result has been a massive relative-price shock, driven by shifts in spending patterns and global prices. This is not the sort of general rise or fall in domestic/demand-driven inflation that central banks normally manage or mete out via macro-stabilisation monetary policy.

• Fiscal push and demand-driven inflation

However, demand-side boosts to growth and inflation – due to joint fiscal/monetary policy responses to the pandemic and war – have also made a substantial difference. The US, more than other major economies, produced a wartime level of fiscal support – $5 trillion in two years, over 20% of GDP cumulatively – substantially financed by Federal Reserve quantitative easing. As a result, US household disposable income, savings and wealth were turbocharged after an initial lockdown-driven collapse in jobs. Europe experienced similar, if smaller, effects. At this point, fiscal and monetary policy were working hand in hand to support households and the economy to different degrees throughout the West.

Once the war began and drove up commodity prices, the US, being nearly self-sufficient, did not suffer as much as Europe, which experienced a massive surge in food and especially energy prices. Fiscal policy came into play once again, as energy price controls were imposed, funded by fiscal subsidies, supporting discretionary spending and pushing headline inflation into core inflation amid the post-pandemic resurgence in demand for services.

Diversity amid widespread policy tightening

• Developed market versus emerging market central banks

The reaction to highflation diverged across developed and emerging market central banks. Many emerging market central banks saw the inflation shock as more persistent and threatening – requiring a sharper, stronger policy response – than most developed markets.

Why? In hindsight, it’s ironic: emerging market central banks worried more than their developed market counterparts about terms-of-trade or supply-side inflation shocks becoming persistent because inflation expectations have long been less anchored in emerging market economies. In other words, emerging market central banks were probably quicker to act because they had to be – their inflation expectations were more adaptive and less inertial. Developed market central banks were in a more comfortable place – some might say complacent. As a result, many emerging market central banks switched quickly from historically aggressive easing with even more aggressive rate hikes than major western central banks, which raised rates more rapidly than in the past several decades of secularly falling inflation.

Views that inflation would prove transitory – and therefore it would be best to look through supply shocks – have proved incomplete at best and downright incorrect at worst. Policy had to be tightened aggressively, yet headline and core inflation are now both starting to fall, and the global economy has proven remarkably resilient.

• Exceptions to the rule: China and Japan

Throughout the resurrection of inflation in the West and many emerging markets, China and Japan have stood out – in different ways. China has the biggest differences, as reflected in being the major economy that stands out for easing policy after reopening, in contrast to hawkishness almost everywhere else. Chinese households experienced more frequent, and arguably more intensive, lockdowns than other countries, with less monetary or fiscal support. Plus, pressures in equity and real estate markets translated into wealth losses, rather than gains. This is probably why excess savings continue to be held rather than spent, unlike in other major economies. This is why China is easing rather than tightening after reopening.

Japan is the only large economy maintaining a dovish/neutral, gradualist approach to normalising – perhaps not even tightening – though for very different reasons than China. China is easing to boost growth and inflation – which are below potential and bordering on deflation, respectively. But the Bank of Japan’s concern is that premature normalisation – and restrictive policy – could cause another false dawn. Decades of deflationary pressures have left expectations anchored too low, unlike in the West and emerging markets. Japan is going to go slow.

Central bank assets and reserves

• Monetary policy portfolios versus reserves portfolios

The combination of high inflation, rapid rate rises and quantitative tightening has inevitably created large losses for major fixed income holders, central banks and private investors alike – in particular where much of the buying was across

SDGs, Targets, and Indicators

SDGs Addressed or Connected to the Issues Highlighted in the Article:

1. SDG 1: No Poverty
2. SDG 2: Zero Hunger
3. SDG 3: Good Health and Well-being
4. SDG 4: Quality Education
5. SDG 5: Gender Equality
6. SDG 8: Decent Work and Economic Growth
7. SDG 10: Reduced Inequalities
8. SDG 11: Sustainable Cities and Communities
9. SDG 12: Responsible Consumption and Production
10. SDG 13: Climate Action
11. SDG 16: Peace, Justice, and Strong Institutions
12. SDG 17: Partnerships for the Goals

Specific Targets Based on the Article’s Content:

• Target 1.2: By 2030, reduce at least by half the proportion of men, women, and children of all ages living in poverty in all its dimensions according to national definitions.
• Target 2.1: By 2030, end hunger and ensure access by all people, in particular the poor and people in vulnerable situations, including infants, to safe, nutritious, and sufficient food all year round.
• Target 3.4: By 2030, reduce by one-third premature mortality from non-communicable diseases through prevention and treatment and promote mental health and well-being.
• Target 4.3: By 2030, ensure equal access for all women and men to affordable and quality technical, vocational, and tertiary education, including university.
• Target 5.1: End all forms of discrimination against all women and girls everywhere.
• Target 8.5: By 2030, achieve full and productive employment and decent work for all women and men, including for young people and persons with disabilities, and equal pay for work of equal value.
• Target 10.2: By 2030, empower and promote the social, economic, and political inclusion of all, irrespective of age, sex, disability, race, ethnicity, origin, religion, or economic or other status.
• Target 11.3: By 2030, enhance inclusive and sustainable urbanization and capacity for participatory, integrated, and sustainable human settlement planning and management in all countries.
• Target 12.2: By 2030, achieve the sustainable management and efficient use of natural resources.
• Target 13.1: Strengthen resilience and adaptive capacity to climate-related hazards and natural disasters in all countries.
• Target 16.6: Develop effective, accountable, and transparent institutions at all levels.
• Target 17.16: Enhance the global partnership for sustainable development.

Indicators Mentioned or Implied in the Article:

• Indicator 1.2.1: Proportion of population living below the international poverty line, by sex, age, employment status, and geographical location (urban/rural).
• Indicator 2.1.1: Prevalence of undernourishment.
• Indicator 3.4.1: Mortality rate attributed to cardiovascular disease, cancer, diabetes, or chronic respiratory disease.
• Indicator 4.3.1: Participation rate of youth and adults in formal and non-formal education and training in the previous 12 months.
• Indicator 5.1.1: Whether or not legal frameworks are in place to promote, enforce, and monitor equality and non-discrimination on the basis of sex.
• Indicator 8.5.1: Average hourly earnings of female and male employees, by occupation, age group, and persons with disabilities.
• Indicator 10.2.1: Proportion of people living below 50 percent of median income, by age, sex, and persons with disabilities.
• Indicator 11.3.1: Ratio of land consumption rate to population growth rate.
• Indicator 12.2.1: Material footprint, material footprint per capita, and material footprint per GDP.
• Indicator 13.1.1: Number of deaths, missing persons, and directly affected persons attributed to disasters per 100,000 population.
• Indicator 16.6.2: Proportion of population satisfied with their last experience of public services.
• Indicator 17.16.1: Number of countries that have national sustainable development strategies, as well as sectoral and regional plans.

Table: SDGs, Targets, and Indicators

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