Sarah Travers
The global economy is standing at a critical juncture, grappling with a combination of high inflation and financial fault lines that could have long-lasting repercussions on prosperity worldwide. As supply chains stabilize and central banks embark on monetary policy tightening, there is a glimmer of hope for a soft landing. However, significant risks loom on the horizon, demanding immediate attention and decisive action from policymakers.
Inflation and the Risk of Persistence
Although global inflation has somewhat receded from its peaks due to the normalization of supply chains and falling commodity prices, there is a concern that high inflation could persist. Wage growth has not kept pace with inflation in many countries, eroding households’ purchasing power. As a result, workers may seek wage increases, and firms, facing higher costs, could pass them on to consumers, creating a self-perpetuating cycle that is challenging to reverse.
Financial Stability Under Threat
The risks to financial stability are another cause for concern. Debt levels and asset prices currently exceed those observed during previous interest-rate hikes. While pandemic-era savings and longer loan terms have provided some buffers, they are gradually depleting, which could lead to a more pronounced slowdown in economic growth than anticipated. Credit losses pose a significant threat, especially to weaker banks, and historical patterns indicate that banking stress often coincides with higher interest rates. The current confluence of high debt, asset prices, and inflation further amplifies these risks.
Challenges for Non-Bank Financial Institutions
Non-bank financial institutions, which have experienced substantial growth since the Great Financial Crisis, are not immune to the impending storm. These investment firms, known for hidden leverage and liquidity mismatches, face stern tests in a higher-for-longer interest rate environment. Business models that flourished under prolonged periods of low rates will now be put to the test, potentially exacerbating financial vulnerabilities.
Government Finances Add to Uncertainty
Shaky government coffers add yet another layer of complexity. If financial instability becomes acute, governments may be compelled to intervene and backstop markets, leading to a growth slowdown and weakened fiscal revenues. This, in turn, could further escalate already elevated levels of public debt, fueling doubts about governments’ ability to meet their obligations and compounding financial instability.
Recommended Policy Responses
In light of these challenges, policymakers must take decisive action to steer the global economy towards stability and safeguard long-term prosperity. Central banks bear the responsibility of restoring price stability as a top priority. However, to provide them with the necessary flexibility to combat inflation effectively, additional measures must be implemented to ensure the safety and stability of the financial system.
Enhanced regulations and tighter bank supervision can help mitigate the faults that have been exposed by recent bank failures. Policymakers are urged to implement Basel III, the international standards for banks developed in response to the 2008 financial crisis, without delay. Moreover, fiscal policy consolidation is crucial in the fight against inflation and to bolster financial resiliency. Building buffers that can be deployed during future downturns is a pressing need.
Taking a Long-Term View
It is imperative that policymakers adopt a longer-term perspective. Monetary and fiscal policies have shouldered a disproportionate burden in sustaining economic growth, testing the limits of what is known as the “region of stability.” This region represents the delicate balance between monetary and fiscal policy that fosters enduring economic and financial stability, while avoiding triggers for high inflation, economic slumps, and crises. Recognizing the shortcomings of repeated emergency actions, governments must reinvigorate long-neglected structural reforms to drive sustainable economic prosperity.
Safeguarding Stability and Embracing Reforms
The challenges faced by the global economy and financial system demand urgent attention and coordinated action from policymakers worldwide. High inflation and financial instability cannot be left unchecked, as they could erode societal trust in policy-making and have severe consequences for economic prosperity. By prioritizing price and financial stability, implementing robust regulations, and embracing structural reforms, governments can navigate the stormy waters ahead and secure a brighter future for the global economy.
