What next for central banks?

Even as central banks are currently struggling to contain inflation and manage currency, they would need to prepare for a prolonged period of uncertainty

Central banks across the world have had to adjust at an extraordinary pace since the beginning of 2020 and the process is likely to continue for some time. The speed and scope of change can be gauged through policy shifts made by the most consequential central bank on the planet, the US Federal Reserve. In early 2020, things looked perfectly in control as the US economy was witnessing a record 11th year of expansion and unemployment was at the lowest level in decades. In his press interaction in January 2020, though Fed Chair Jerome Powell did refer to uncertainties related to the coronavirus, perhaps no one expected the world’s largest economy to slip into one of the deepest recessions virtually in a matter of days. It was later declared that the recession started in February 2020.

The Fed not only quickly cut interest rates to near zero but also flooded the system with liquidity and invoked emergency powers to support practically any entity. In an interaction in May 2020, for instance, Mr Powell said: “We crossed a lot of red lines that had not been crossed before.” He further noted that it was the kind of situation where one does such things and figures them out later. But that time came much sooner than a lot of people had expected.

The size of the Fed balance sheet expanded by about 70 per cent between February and May 2020. While policy interventions led to a swift recovery, too much money also did what it is usually supposed to do: Push up prices. The inflation rate in the US is running over 8 per cent, way above the medium-term target of 2 per cent. The story in other parts of the world is more complicated. Central banks in Europe, for example, are more constrained in terms of responding to inflation, while many in emerging markets have to tighten policy despite a weak recovery. To be sure, aside from central bank interventions, massive fiscal push in advanced economies and supply chain disruptions in various parts of the world also played a part.  Last week, the Fed raised its policy rate by 75 basis points for the third time in a row. In his remarks, Mr Powell this time noted that no one knows if the Fed’s action will lead to a recession and how significant it would be.

Differently put, containing the fallout of interventions made to enable a swift recovery from the pandemic-induced recession could lead to another recession. The latest projections by Fed members suggest that interest rates could go up by over 100 basis points before the end of the year. Such a steep increase in interest rates by the Fed will have consequences. Other large central banks in advanced economies may not be able to match the Fed’s resolve. As a result, the US dollar is strengthening and has led to turmoil in the global currency markets. There are now also concerns that simultaneous policy action by large central banks might lead to higher than the desired tightening in financial conditions. As the World Bank recently noted, the global economy may be edging towards a recession and a series of financial crises in emerging markets. Countries with high foreign debt or higher current account deficit will increasingly face more difficulties.

The current phase is clearly one of the most challenging periods for central banks in recent decades. It is likely that inflation conditions would stabilise in the near term, though the rate may remain above the medium-term target for some time. Thus, relatively higher interest rates in advanced economies, especially the US, for a considerable period would make life difficult for policymakers in developing countries, particularly when output is expected to remain weak.  India clearly is not immune to what's happening around the world. It also took a number of conventional and unconventional steps during the pandemic, and is now dealing with high inflation. Although the Reserve Bank of India (RBI) started a bit late in terms of policy adjustment, the disinflation required in India is lower compared to advanced economies. But it still has to contain inflation and deal with currency market pressures which can affect prices. The rupee has remained resilient compared to other currencies because of sustained intervention by the RBI. Since the external environment is unlikely to improve significantly in the near term, the RBI would need to adjust its currency policy.

At a broader level, even as most central banks are currently struggling to contain inflation and manage currency, they would need to prepare for a prolonged period of uncertainty. The evolving geopolitical situation, for example, could reverse part of the productivity gains realised in recent decades, which resulted in lower prices. The apparent shift in supply chains and trade linkages could put sustained upward pressure on prices, at least for some time. This would mean central banks may have to operate in an environment of relatively higher inflation and lower economic growth. How long such a phase could last will be hard to guess, given other challenges such as the ageing population and climate change.

In such a situation, central banks in developing countries like India would do well to build protection. This would essentially mean maintaining low and stable inflation with a healthy cover of foreign exchange reserves. The record shows policymakers in advanced economies are usually not worried about what happens in other parts of the world. India’s resilience will also depend on government policy choices, particularly in areas of fiscal management and trade. Slippages in these areas would increase external vulnerability and affect longer-term growth prospects.