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Post-pandemic inflation: 7 lessons for monetary policy

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After COVID-19, inflation in many countries rose to levels not seen in 40 years, testing central banks around the world.

A new e-book, “Monetary Policy Responses to the Post-Pandemic Inflation,” published by the Centre for Economic Policy Research, explores the effectiveness of central banks’ strategies, frameworks, and tools as they struggled to respond.

In a column previewing the book, MIT Sloan economist and co-editors Bill English of the Yale School of Management and Ángel Ubide, a managing director at Citadel, offer insights to help policymakers better tackle the next inflationary episode.

“An overarching lesson for central banks is the importance of symmetry in their responses to low and high inflation,” the authors conclude.

This excerpt from the column has been edited for style and length.

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Seven lessons for monetary policy

The size and persistence of post-pandemic inflation shocks, the associated forecasting mistakes, and the losses from swollen balance sheets have generated significant criticism of central banks. What are some lessons for the future?

First, inflation forecasting must be improved. Inflation is difficult to forecast, even in tranquil times. It becomes materially more difficult after a series of supply and global shocks. Forecasting is especially difficult if the effects are nonlinear or the effects interact with the state of the economy, as there may be limited historical experience to identify the break points. Capturing inflation dynamics may now require new approaches and new data. 

Second, the standard textbook response of simply “looking through” supply shocks must be revisited. Instead, it is necessary to incorporate a careful analysis of the current stance of policy, the nature and duration of the shock(s), and the appropriate management of risks in each direction. The textbook response assumes that the policy setting is appropriate absent the shock, that the supply shock will not affect inflation expectations or wage- and price-setting behavior, and that the inflation risks are symmetric. Each of these assumptions, however, was on shaky ground during the post-pandemic inflation.

Third, interest rates remain the primary instrument for tightening policy and bringing down inflation. Central banks relied on a wide range of tools to ease policy and support their economies during the pandemic (such as balance sheet policies, forward guidance, exchange rate intervention, and programs supporting banks, credit, and liquidity). In contrast, central banks quickly reaffirmed that interest rates were the main instrument for tightening monetary policy and bringing down inflation. This asymmetry reflects the constraint of the effective lower bound on interest rates, as well as banks’ limited experience using balance sheets to tighten policy.

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Fourth, central banks should maintain flexibility and a willingness to adjust policy in either direction. Some easing tools — such as quantitative easing, forward guidance, and yield curve control — rely on their persistence and expectations of future action (or lack of action) for their effectiveness. This feature can make these policies difficult to change quickly. Clearer communication, aided by well-defined, state-contingent triggers or thresholds, is needed to make it easier to adjust these policies sooner than anticipated if the economic outlook changes.

Fifth, central banks should discuss how fiscal policy could affect the economic outlook, risks, and overall price stability. Fiscal policy bolstered central banks’ efforts to support the economy during the pandemic. When commodity prices spiked, the array of energy price caps and subsidies limited the impact on inflation expectations, supported incomes, and had important effects on inflation dynamics more broadly. While central banks may assume the continuation of “current policies” in their baseline forecasts, they should make greater use of alternative scenarios that reflect how some of these measures would change their inflation forecasts.

Sixth, monetary policy will have a much larger effect on the fiscal outlook in the future, potentially leading to more political pressure on central banks. Although it is unclear where interest rates will settle, it is unlikely that they will fall back to the very low levels seen before the pandemic. The extent to which higher interest rates will affect public finances over the medium term will depend on many factors, but what is clear is that higher debt-to-GDP ratios and higher interest rates have materially narrowed the room for fiscal policy mistakes.

Finally, central banks must be able to achieve their monetary policy goals while supporting financial stability. As central banks accelerated interest rate hikes, several financial institutions and sectors came under stress (such as the liability-driven investment sector in the U.K., regional banks in the U.S., and Credit Suisse in Europe). Central banks should plan for these types of situations when financial stability concerns could require actions that seem to work against monetary goals. For example, they should plan in advance for ways to reinforce their liquidity standing facilities if needed to provide emergency liquidity or to support market functioning in periods of systemic stress — all in ways that minimize the impact on monetary policy.

Excerpted from “Monetary Policy Responses to the Post-Pandemic Inflation: Challenges and Lessons for the Future,” by Bill English, Kristin Forbes, and Ángel Ubide.

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For more info Tracy Mayor Senior Associate Director, Editorial (617) 253-0065