The risks of a simultaneous and rapid global tightening

In a bid to bring inflation down to target, most central banks in advanced economies have embarked this summer on a policy-tightening process unseen since the 1980s.

However, some multilateral organisations and leading economists warn institutions should co-ordinate their decisions and increase interest rates at a more gradual pace. Otherwise, they risk plunging the world economy into a severe recession.

“The simultaneous tightening of monetary and fiscal policies across the world will likely prove complementary in reducing inflation,” says the World Bank in a recent report. “However, since they are highly synchronous across countries, they could be mutually compounding, and produce cumulative effects that are larger than envisioned – both in tightening financial conditions and in steepening the global growth slowdown.”

Following over three decades of stable inflation, in 2021 central banks in advanced economies dismissed higher inflation readings as a transitory phenomenon. Most officials argued rising inflation was linked to the reopening of economies after the lockdowns imposed to contain Covid-19, and to the supply chain bottlenecks derived from shifting demand patterns away from services and towards goods.

In contrast, central banks in emerging economies, where high inflation had caused major economic and social crises as recently as the 1990s, were faster to increase rates. For instance, the Central Bank of Brazil hiked the Selic rate as soon as March 2021, the Central Bank of Chile followed suit in July, and the Central Reserve Bank of Peru in August.

Stubbornly rising inflation ultimately unleashed a monetary policy U-turn among advanced economy central banks. The US Federal Reserve has increased the policy rate by 300 basis points so far this year, as has the Bank of Canada. The Reserve Bank of Australia and the Reserve Bank of New Zealand have boosted rates by 225bp each, the Bank of England by 200bp, Norges Bank and Sveriges Riksbank by 175bp. Even the European Central Bank and the Swiss National Bank have increased rates by 125bp each, both abandoning negative interest rates.

Furthermore, the process has dramatically accelerated over the last few months as central banks have abandoned the previously common 25bp rate increases in favour of much larger adjustments. The BoC and the Riksbank have implemented 100bp increases, the Fed three consecutive 75bp moves, and the ECB and SNB increased their policy rates by 75bp once earlier this month. What is more, almost all these institutions are signalling more interest rate increases until they see solid signals that inflation will return to their targets through their projection horizons.

Nonetheless, as they were late to acknowledge how the pandemic and later the Russian invasion of Ukraine had contributed to higher inflation, central banks may be incurring a second mistake while attempting to address the first one.

“Just as central banks (especially those of the richer countries) misread the factors driving inflation when it was rising in 2021, they may also be underestimating the speed with which inflation could fall as their economies slow,” says Maurice Obstfeld, senior fellow at the Peterson Institute for International Economics and former IMF chief economist.

In the research note, he adds: “By simultaneously raising interest rates, they amplify each other’s policy impact and, if this feedback loop isn’t taken into account, could drive the global economy into recession.”

Lack of co-ordination

As a result of this global reaction, some prominent voices are stressing the importance that central banks co-ordinate their response to higher inflation, as they did during the great financial crisis or during the early phase of the pandemic.

Facing a sharp economic contraction, in those crises central banks took interest rates to record low levels, and the Fed opened liquidity swap lines with key central banks in advanced and emerging economies in a bid to secure adequate dollar liquidity levels.

Another episode of international co-operation was the Plaza Accord of September 1985. Back then, France, West Germany, Japan, the UK and the US agreed to depreciate the US dollar in relation to the French franc, the Deutschmark, the yen and sterling.

The decision was meant to reduce the US current account deficit, making the country’s exporters more competitive. Following the sharp interest rate increases led by former Fed chair Paul Volcker from 1979 to tame inflation, the dollar appreciated, harming US exporters’ competitiveness in relation to their German and Japanese peers. Partly as a result, the US current account balance deteriorated from -0.15% of GDP in 1981 to -2.7% in 1985, according to IMF data.

Two years later the Louvre Accord aimed to stall the dollar’s decline, stabilising currency markets. On that occasion, Canada joined the signatories of the Plaza Accord.

Nonetheless, in the current inflationary environment, there are no signs of this kind of dialogue.

“I am struck by the lack of common international commitment, and international signalling, for there to be a general recognition of the salience of inflation as a central problem, and of the challenges that will face the developing world as a consequence of the necessary adjustments in the industrial world,” said former US Treasury secretary Larry Summers on September 13.

In Summers’s view, conveying “the sense that there is a collective macroeconomic management globally would reinforce everybody’s credibility in a very valuable way”.

On September 21, as the Fed announced a new 75bp increase, Kenyan central bank governor Patrick Njoroge stressed the risks emerging markets face as capital seeks higher returns in the US, and liquidity drops elsewhere.

“The thing that concerns us is the policies that are being adopted in the advanced economies, the rapid increase in interest rates that we are now witnessing,” said Njoroge in an interview with Bloomberg TV. “That will have implications in financial markets, they have indeed frozen us out. And it is difficult for us to maintain our relationships in the capital markets.”

Despite these risks, central banks remain focused on the domestic situation. In a global regime of flexible exchange rates this may be the best way to address high inflation, some officials argue. “It’s hard to talk about collaboration in a world where people have very different levels of interest rates,” said the Fed chair Jerome Powell in a press conference on September 21. “There were co-ordinated cuts and raises at various times, but we’re all in very different situations.”

Powell added Fed officials regularly discuss international monetary policy with peers at forums such as the Bank for International Settlements (BIS) in Basel. “So we are very aware of what’s going on in other economies around the world and what that means for us, and vice-versa. Our forecasts… try to take all of that into account.”

Exporting inflation

In addition to added stress in emerging economies, the simultaneous tightening could be counterproductive for advanced economies too.

“When a country hikes its interest rate, foreign currencies depreciate against it, and to the extent that its exports are invoiced in the home currency, its trade partners’ import prices will rise,” points out Obstfeld. “In other words, monetary tightening during a worldwide inflation surge can be a beggar-thy-neighbour policy when it effectively exports inflation to trade partners.”

In a highly connected trading system, this dynamic could reinforce itself, forcing central banks to hike ever higher. Although several major central banks play a significant role, the Fed’s decisions have a much greater influence due to the outsized role the US dollar plays in financial markets, in commodities trading, and overall global transactions.

The US economy represents around 24% of global GDP. According to the World Trade Organization, total trade in goods and services amounted to $22 trillion in 2020. World Bank data shows that same year, US exports reached $1.4 trillion, and imports $2.4 trillion, for a combined total of $3.8 trillion (17.2% of world trade).

However, the dollar’s financial dimension is far larger, points out recent research by Obstfeld and Haonan Zhou, published by the Brookings Institution earlier this month.

In total, 59% of allocated international reserves are denominated in dollars. Its share of global FX transactions is over 85%. More than 50% of cross-border loans are denominated in dollars, as well as close to 50% of international trade invoicing, over 45% of international debt securities and 42% of Swift payments.

In this environment, higher interest rates act like a magnet attracting international capital, thus boosting the dollar’s value. So far this year, the Bloomberg dollar spot index has risen by 14.8%, as the currency has reached multi-decade highs against the euro, sterling and yen.

In turn, the eurozone, UK and Japan see their import prices rise at a time when their economies are already suffering high inflation. In this context, on September 22, Japanese authorities announced the first FX interventions to defend the yen’s value since 1998.

In a globalised financial and economic system, “policy-makers must consider other central banks’ actions when setting their own rates,” says Obstfeld. He argues trade integration means foreign labour market conditions have a greater influence on domestic prices. Additionally, financial integration speeds up spillovers stemming from tighter financial conditions globally.

“Globalisation raises the stakes of doing too much,” stresses Obstfeld. The former IMF chief economist argues that in order to avoid a sharper economic contraction than what is needed to lower inflation, central banks should co-ordinate a more gradual tightening of monetary policy and communicate with clarity their next steps.

“They co-ordinated monetary policy responses effectively during the global financial crisis, and the current inflationary dilemma merits an equally collaborative approach,” Obstfeld says.

The World Bank agrees with this analysis. In fact, its research concludes that the global economy could avoid a recession even in the case that monetary policy needs to be tightened beyond current market expectations.

“However, this would require the additional tightening to be implemented in such a way as to generate an orderly adjustment in financial markets,” says the World Bank report. “Central banks must communicate their policy decisions clearly within credible monetary policy frameworks, while safeguarding their independence.”

The multilateral organisation concludes this strategy would help to anchor inflation expectations, reducing the level of interest rate increases needed to bring inflation back to target.