By Gita Gopinath
– At the Annual Conference of the Central Bank of Brazil, Brasilia, May 17, 2023.
Fighting inflation remains the priority of central banks around the globe. This is no easy task, given that growth is slowing, and financial stresses could intensify. [Today], I’ll focus on the challenges that emerging markets (EMs) face in bringing down inflation, which is running at multi-decade highs.
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I will focus on four key issues:
- First, EMs have performed well so far in the face of rapid tightening by advanced economies (AEs). What accounts for the solid performance of EMs?
- Second, core inflation remains far above central bank targets. What is the appropriate strategy for bringing inflation back down?
- Third, how should EM central banks respond to financial stresses, which may pose tradeoffs in achieving price stability goals?
- Finally, how can fiscal policy help the fight against inflation?
Solid EM performance amid rising rates
The sharp tightening of monetary policy in advanced economies, especially the US, has often triggered financial stress or even crises in EMs. Owing to higher credit and currency risks in EMs, global investors have typically pulled out quickly when AE interest rates have risen.
This was the case in the 1980s and again in the mid-1990s. At the time, investors had several concerns about EMs: high levels of debt, often short-term in duration and denominated in foreign currency; low international reserves, and weak policy frameworks, for example.
The recent tightening cycle has played out differently. In response to rising domestic inflation, EMs on average tightened monetary policy starting in mid-2021, much earlier than AEs (slide 3, left panel).
Remarkably, EM economies have thus far proven resilient both to their own policy tightening and tightening by AEs, where rates have risen at the sharpest pace in several decades. EM growth remained strong through last year and is expected to hold up reasonably well this year, while capital outflows have been limited. Outflows from Latin America, for instance, have been far smaller than during the Taper Tantrum of 2013 (slide 3, right panel). Some EM currencies have even appreciated against the dollar.
What accounts for the strong performance of EMs? One critical factor is the reforms EMs have put in place over the last couple decades. These reforms have helped lower credit and currency risks.
EM central banks have improved their monetary policy frameworks and benefited from greater independence. They have moved toward greater exchange rate flexibility and transitioned from using the exchange rate as a nominal anchor to flexible inflation targeting (slide 4, left panel). Higher policy transparency has allowed investors to ascertain risks better and be less prone to flee during periods of global financial tightening.
The success of EM central banks at delivering low inflation has helped anchor long-term inflation expectations around announced targets (slide 4, right panel blue line). Long-term inflation expectations are less responsive to near-term developments (right panel red line), and there is less variance of long-term inflation forecasts across different analysts. While building monetary policy credibility is an ongoing challenge, EMs are better prepared for the formidable task of tackling today’s high inflation.
EMs have also made important strides in enhancing financial stability. This includes ensuring that EM banks are better capitalized (slide 5, left panel). In addition, they have taken many steps to strengthen regulatory, supervisory, and macro-prudential frameworks to limit risk-taking and foreign exchange (FX) mismatches.
At the same time, EMs have implemented structural reforms to encourage the development of local currency bond markets and built sizeable buffers of FX reserves (slide 5, right panel), reducing the risk of debt default from FX borrowing. EMs have also benefited from improved fiscal frameworks that strengthen debt sustainability.
These advances are important and have served EMs well so far. At the same time, it is important to remain mindful that considerable downside risks from monetary policy tightening on EMs remain. Conditions may still get significantly worse. For instance, rate hikes in the US have thus far come with still-benign conditions, but this might well change in the period ahead.
Turning to the outlook for EM inflation, financial markets appear encouraged by the resilience they’ve seen, and by ongoing declines in headline inflation. While there is considerable divergence across EMs in their inflation rates, markets expect inflation to decline fairly quickly to target across EMs (slide 6, left panel), without much of a hit to economic growth. And they expect lower inflation will allow EM central banks to begin making rate cuts later this year (right panel).
Despite this optimism, inflation in many Ems – as in advanced economies – as been unexpectedly high and persistent (slide 7, left panel). In fact, inflation has consistently surprised on the upside. While goods inflation has declined sharply or even turned negative, inflation in services has been strong (right panel). Moreover, policy tightening hasn’t cooled labor markets significantly, and wage growth remains robust in many EMs.
Risk management strategy for monetary policy
We don’t yet know exactly what accounts for the stickiness of inflation, but several factors are likely at play and pose upside inflation risks going forward.
First, while monetary policy has tightened substantially in many EMs, activity hasn’t slowed that much, leaving unemployment near historic lows. Of course, monetary policy works with long and variable lags, and the full effects of recent policy tightening have yet to be felt.
But the transmission of monetary policy thus far appears less forceful than might have been expected. This could reflect tailwinds to growth from strong pent-up demand following the pandemic, and strong balance sheets from earlier fiscal and monetary policy support, both reducing interest sensitivity.
Second, we’ve seen a strong rotation of demand from goods to services. This can generate persistent inflation pressures because demand for services tends to be less interest-rate sensitive. Services also tend to be labor intensive and wage growth is unlikely to come down quickly.
Third, it seems likely that the pandemic has lowered potential output and employment, which would tend to increase upward pressures on both labor costs and inflation. It has also taken a while for supply-chain bottlenecks to unwind.
While there is considerable uncertainty about the inflation outlook, and downside as well as upside risks, I’m more concerned than markets about sizeable upside inflation risks. There are few historical precedents for inflation coming down from very high levels without a significant economic slowdown. Thus, the fact that labor markets and activity remain quite strong suggests we may see considerable upward pressure on inflation.
These upward pressures would intensify if the natural rate of unemployment, U*, has risen significantly and labor markets are hotter than typically estimated. While it is always difficult to measure U* and potential output, the possibility that the potential employment and output has fallen more than estimated following the pandemic is sizeable, and a key upside inflation risk.
There’s also reason to be concerned that sustained high inflation could change inflation dynamics. Rather than absorbing increases in factor costs into their profit margins, firms would feel more comfortable passing them on, and workers would demand payback for real wage losses. In other words, the longer inflation stays high, the harder it could become to bring it down – and the larger the contraction of output that would be required.
This risk is especially relevant for EMs, where inflation expectations are less well anchored, and wage and price indexation are more prevalent than in AEs. And these economies are more vulnerable to upside inflation surprises given higher pass-through of exchange rate and energy shocks to core inflation (slide 9, right chart).
All in all, there’s a strong rationale for central banks maintaining a tight policy stance and reacting aggressively to upside inflation surprises.
Structural models offer insights into these challenges. Models show that the policy reaction function should become more aggressive in responding to inflation when inflation has a substantial backward-looking component that may reflect formal indexation arrangements or adaptive expectations. In those situations, positive demand or cost-push shocks have longer-lived effects.
It’s helpful to consider optimal policy in a simple New Keynesian model with backward indexation that drives persistence. In this model, the persistence parameter is iP and the output gap x, and the policymaker is assumed to minimize a loss function that depends on the variance of the output gap and inflation (relative to target). The optimal reaction function calls for pushing output below potential to a greater extent when inflation is more persistent.
This scenario illustrates the problems that may arise if monetary policy reacts to an inflation shock – here a cost-push shock – using a rule that is optimal when inflation persistence is quite low, when in fact structural persistence is much higher (slide 10, charts on right). The fairly passive rule – shown by the red dashed lines – allows inflation to rise by much more than the rule based on the “correct” persistence parameter shown by the solid blue lines. While output losses are smaller initially under the more passive rule, such a rule leaves the central bank with a bigger inflation problem. And if the policymaker catches on after some time and follows the optimal rule with the correct persistence parameter, inflation can be brought down faster, but at the cost of a deeper downturn than if the persistence of inflation was recognized at the onset (slide 11, charts on right).
Monetary policy and financial stress
While major EM economies have done well in weathering both their own policy tightening and financial problems in AEs, they could still be hit by financial stress.
These stresses may affect EMs differently than what we’ve seen in the US, where large unrealized losses due to duration mismatch have unnerved investors and precipitated bank runs. EMs can be more exposed to credit and exchange-rate risk arising from slowing domestic activity or capital outflows. Increased sovereign vulnerabilities in this environment may trigger stress in the banking system and weaken the macro-economy. Pressures are also heightened from borrowing in foreign currency, especially at short horizons.
EM central banks have ways to reduce tensions between their price and financial stability objectives. These include ex-ante tools, such as macroprudential tools, and preemptive CFM/MPMs, but also tools that can be used in the event of stress, such as longer-term discount window lending, repos, asset purchases, and lending in FX, which is sometimes supported by central bank swap lines. Many EMs provided liquidity support during COVID and found these interventions effective at reducing financial stress.
However, like AE central banks, they need to be careful how they use these tools. Expanding their balance sheets while fighting inflation could lead to confusion about the stance of monetary policy, heighten exposure to credit or maturity risk, and raise political concerns about “picking winners and losers.” Accordingly, it is important to put a high bar on such interventions, ensuring they are temporary and targeted.
EM central banks may also face mounting external pressures, including if global financial conditions tighten sharply, causing an exodus from EM assets. The Fund’s integrated policy framework (IPF) is helpful in identifying conditions under which foreign exchange intervention (FXI) and capital-flow management (CFM) measures may be helpful in improving the policy tradeoffs facing EM central banks. Fund staff have developed and applied both conceptual and more quantitative models to illustrate how these tools should be used, and research is ongoing.
The use of these tools should be guided by a careful analysis of friction and the nature of shocks. Allowing the exchange rate to adjust flexibly is desirable if FX markets are reasonably deep, the shocks are mainly to fundamentals such as commodity prices, and the risk of financial stresses is modest.
The case for FXI is stronger if FX market depth is low and the economy faces external financial shocks associated with deteriorating investor sentiment. Even in this case, the central bank must recognize the intertemporal tradeoffs involved in using FXI to support the exchange rate, including the risk that it may compromise its ability to provide liquidity support in FX.
Fiscal policy and inflation
Some of the side effects of fighting inflation with monetary policy, including the financial stresses just mentioned, can be reduced by allowing fiscal policy to play a bigger role. Governments can – and should – prioritize the needs of the most vulnerable while scaling back broad-based fiscal support that isn’t warranted in a high-inflation environment.
IMF staff are using both empirical and structural models to assess how fiscal policy can help the fight against inflation. The slide shows results from a stylized two-country DSGE model that considers two different approaches to lowering inflation (slide 16). The first relies exclusively on monetary tightening to cool the overheating economy, whereas the second involves fiscal consolidation. The scenario calibrates the monetary and fiscal tightening, so the GDP effects are essentially identical.
Both approaches are clearly effective in lowering inflation (left panel). However, they work through different channels: monetary tightening reduces demand by boosting interest rates and causing the currency to appreciate, whereas fiscal tightening cools demand without the need for interest rates to rise – in fact, interest rates fall somewhat (middle panel) and the currency tends to depreciate. Moreover, monetary tightening causes government debt to rise given the higher debt servicing costs and adverse effects of the economic slowdown on the primary balance, whereas government debt falls in the case of fiscal consolidation (right panel).
Conversely, broad-based fiscal support would either force the central bank to slam on the brakes to curb inflation – as illustrated in the model scenario showing the effects of one-percentage-point-of-GDP fiscal expansion – or cause inflation to rise more, potentially leading to de-anchoring if the central bank chose to accommodate (slide 17, left and middle panels). Public debt would eventually increase under either approach, but especially under the more forceful monetary policy tightening (right panel).
Thus, broad-based fiscal expansion is counterproductive for economies fighting high inflation, especially EMs. Analytical work by IMF staff, including in the Fiscal Monitor and Global Financial Stability Report, shows how higher public debt in EMs makes them more vulnerable to sovereign default (slide 18, left panel) and tends to raise sovereign spreads.
Weak fiscal positions can heighten the risk of an adverse sovereign-bank nexus, in which declines in sovereign bond prices hurt the banks, and the weaker macro outlook in turn undermines the sovereign’s creditworthiness, including through fiscal channels.
Weak fiscal positions can also increase risks of fiscal dominance, especially in an environment of high inflation where the fiscal authorities may fear that tight monetary policy will further weaken public sector balances and the macro-economy. IMF research has shown how deteriorating fiscal positions in EMs tend to put upward pressure on long-term inflation expectations, complicating the task of monetary policy (right panel).
All told, fiscal restraint can mitigate the challenge of bringing down inflation and reducing financial vulnerabilities that make the fight against inflation even harder.
To conclude, I’ve argued that markets are probably too optimistic about what it will take to bring down inflation in EMs. Despite encouraging signs, I am worried that price pressures seem entrenched in many economies and that upside inflation risks are sizeable. Hence central banks must remain resolute in keeping policies tight and recognize that insufficient monetary tightening now may necessitate even more painful actions down the road – a lesson from the high inflation period of the 1970s that very much applies today. Fiscal restraint can help support the fight against inflation by central banks. And financial tools – judiciously used – can improve tradeoffs in the event of pronounced financial stress.
While these challenges are global, they are heightened for EMs. Hence it is critical for EM authorities to refine and strengthen their monetary, fiscal, and financial policy frameworks. Central bank independence should be maintained, alongside further enhancements in transparency and communication. Better policy frameworks – both monetary and financial have allowed EM central banks to pursue countercyclical policies during both the Global Financial Crisis and COVID pandemic.
These frameworks have helped EMs hold up well in the face of the sharpest tightening of monetary policy in advanced economies in several decades. And they should continue to serve as an anchor of stability to help navigate the challenging road ahead.
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