27.08.2022
The current time and the next period, at least for a number of years, will be more insidious for monetary policy. This is due to the fact that the era of low inflation and low interest rates is ending and a new one is beginning, when there will be more compromises and fewer options. The period of disinflation that began in the 1980s was accompanied by accelerated globalization, lengthening of supply chains, automation and offshoring of manufacturing, and concomitant growth in the service sector. Labor markets have changed and, in most cases, income inequality has worsened. Economic growth has been weaker and productivity slower, especially since the 2008 global financial crisis. These were times of deflationary macroeconomics, when expansionary policies are less inflationary and generate more debt than growth. The end of globalization as we know it, the post-Covid reorientation of global value chains, and the ongoing energy and food crisis are ushering in a new era. Inflation may not be as fleeting as originally thought, and central banks will have no choice but to focus on fighting it or risk their credibility. Eventually central banks will get inflation under control , but that could take longer and cost more than we currently think. In this article, we will discuss the changing landscape of monetary policy and leave the recent policy decisions of the central bank for another time. Eventually central banks will get inflation under control , but that could take longer and cost more than we currently think. In this article, we will discuss the changing landscape of monetary policy and leave the recent policy decisions of the central bank for another time. Eventually central banks will get inflation under control , but that could take longer and cost more than we currently think. In this article, we will discuss the changing landscape of monetary policy and leave the recent policy decisions of the central bank for another time.
Over the past 30 years or so, policy, fiscal and monetary, has had a significant expansionary bias, but growth, especially since the 2008 global financial crisis, has been weak and inflation has been low for a long time. Central bank credibility and inflation targeting, a legacy of the 1980s, have played their part. But the slowdown in growth, globalization and the massive accumulation of debt also played a role.
Monetary policy was overly expansionary. The economy is cyclical, and over the past 30 years, monetary policy has gone from easy to tight, from low to high interest rates. But each time, at the peak of the tightening cycle, interest rates will be lower than the previous time, and at the bottom of the expansion cycle, interest rates will be lower than the previous time until the bottom is reached. Between December 2008 and February 2022, the policy interest rates of the Federal Reserve and the ECB averaged 0.4% per annum and were at or near zero most of that time. This meant massive asset purchases, and at the end of February 2022, for example, the Federal Reserve had a balance sheet of about nine trillion, ten times what it was in 2007. It’s the same with the ECB.
During the same period, fiscal policy was also expansionary. On average in the EU, the budget deficit worsened between 2008 and 2014 due to the global financial crisis and its aftermath, and the debt-to-GDP ratio rose sharply from 62 to 87 percent. The budget deficit also worsened sharply in 2020-21 in the wake of the Covid-19 pandemic, with the debt ratio hitting 90 percent in 2020. More importantly, there were significant differences between countries. The average debt ratio in the northern core was about 50 percent in 2021. At the same time, the average debt ratio of the most indebted countries, mostly in the southern core, was 135 percent. Greece’s debt ratio was 193 percent, while Italy’s was 151 percent. Cyprus” amounted to 104 percent.
Based on growth experience, these levels of debt would be unsustainable if interest rates were higher. The average EU public debt interest rate was 1.4% of GDP in 2021, compared to 2.9% in 2012, even though debt was higher relative to GDP in 2021 . at the level of public debt relative to GDP pose a threat, although not an immediate one. When inflation rises, the debt burden is initially reduced until most of the outstanding debt is refinanced at higher interest rates. The problem here is Italy, which has the second-highest debt relative to GDP but the highest interest expense in the euro area relative to GDP. Cyprus is not in a very troubling position in this respect. Its debt-to-GDP ratio is a third less than that of Italy, and its interest expense is about half that of Italy.
Low inflation and its causes
Another key feature of this period was low inflation amid unprecedented monetary and fiscal expansion. This, of course, until recently. This was the result of three main factors: confidence in the central bank; Influence of Philips curve type; and the impact of globalization.
Central banks play an extremely important role in anchoring inflationary expectations, without which it is impossible to control inflation. The combination of an independent central bank and inflation targeting restored confidence in the central bank after the hard experience of the 1970s and helped keep inflation expectations stable. Big positive.
The influence of the Phillips curve refers to the infamous relationship between economic growth and inflation, named after the New Zealand economist who first discovered it in the 1950s. We are talking about a positive relationship between economic growth and inflation, which for our purposes is empirically true on a cross-country basis. Looking at the corresponding data for the period 2008-2021, for all EU countries, countries with low growth rates are in most cases also countries with low inflation, and countries with higher growth rates are also countries with higher inflation. In a country like Greece, for example , this period was on average deflationary. Average inflation during this period was less than 1 percent per year, and the growth rate was negative at almost -2 percent per year. Similarly, in Italy, growth was marginally negative, with inflation slightly above 1 percent. In countries such as Hungary, Romania, Lithuania and Poland, inflation and growth exceeded 2 percent during this period. If central banks were able to anchor inflationary expectations, economic weakness was also the main reason for low inflation during this period.
This reveals another relationship between debt and economic growth and its impact on inflation. Again, examining cross-country data showing the debt-to-GDP ratio and average growth over the same period as for the Phillips curve ratio above, 2008-2021, shows that economic growth is lower where debt is higher. The five most indebted countries (Greece, Italy, Portugal, Spain and France) also had the lowest growth rates over the period. Countries with the lowest gross debt to GDP ratio, mostly less than 60 percent, have the highest growth rates (all northern, core Malta countries and many Eastern and Central European countries).
In conclusion
There is nothing magical about money. Weak growth breeds low inflation. Monetary expansion and low interest rates do not necessarily lead to growth when the real economy is weak and growth prospects are modest. After a long period of expansionary policies, central banks in the US and Europe ended up with bloated balance sheets and their respective governments with large accumulated debts relative to GDP. When exogenous shocks, such as the Covid-19 pandemic or the war in Ukraine, hurt supply more than demand, inflation is the stimulus. This is something that perhaps central banks on both ends of the Atlantic, in the US and Europe, failed to address early on. Scarcity rooted in war, geopolitical rivalries and Covid-related disruptions, as well as in the process of reverse globalization and the re-or near-fixation of value chains, will be permanent . fighting inflation will be more difficult and expensive. Monetary policy will find itself in a new landscape, especially in Europe.
Ioannis Tirkides is Manager of Economic Research at the Bank of Cyprus and President of the Cyprus Economic Society. The opinions expressed are personal. The article was also published on the blog of the Cyprus Economic Society
