Central banks must accept the “inconvenient truth” that they may have to tolerate a longer period of inflation above the 2 percent target to prevent a financial crisis, the IMF’s deputy chief has warned.
Gita Gopinath told the European Central Bank’s annual conference in Sintra, Portugal, that policymakers risk facing a tough choice between allowing a future financial disaster among heavily indebted countries and raising borrowing costs enough to tame stubborn inflation.
“We’re not there yet, but it’s a possibility,” Gopinath told the Financial Times ahead of his speech. “In this environment, you can see central banks adjusting their response function and saying, ‘Okay, maybe we’ll tolerate inflation being higher for a little while longer.’
The high debt levels of many European governments make them vulnerable to another financial crisis, said Gopinath, who last year was promoted from the IMF’s chief economist to its deputy managing director.
“We’re entering a period where we have to admit that inflation is taking too long to get to the target – that’s my first uncomfortable truth – and that means we run the risk of inflation taking hold,” Gopinath said.
“When governments lack the fiscal space or policy support to respond to the problem, central banks may need to adjust their monetary policy response function to account for financial stress,” she said in her speech.
But she added that there must be a “high bar” before leading central banks accept inflation staying above their 2% target for longer, because that could make price growth even stronger, as it has in the USA in the 1960s.
Financial stress in the euro area “may also have different regional effects, with (interest) spreads widening more in some highly indebted economies” and this may “reinforce other vulnerabilities stemming from household indebtedness and a large share of variable rate mortgages in some countries,” she said.
Gopinath said in his speech that the ECB and other central banks “must be prepared to respond vigorously” to signs of persistent inflation, even if that leads to “much more cooling” in labor markets.
The ECB has already raised its benchmark deposit rate at an unprecedented pace from minus 0.5% last year to 3.5% earlier this month and has signaled that another quarter-point hike is “highly likely” in July.
Governments could also help fight inflation by cutting deficit-financed spending to reduce demand and reduce the amount by which the ECB has to raise rates, she said.
“Given the economic conditions we have, both high inflation and record debt levels, both would call for a tightening of fiscal policy,” she said. “If you look at the projected fiscal deficits for many G7 countries, they look too high for too long.”
The ECB set up a bond-buying program called the transmission protection tool, designed to avoid rising borrowing costs triggering a new sovereign debt crisis in the eurozone. But that hasn’t been tested, and Gopinath said more could be done to prepare for potential financial stress.
She urged EU governments to agree new rules to reduce their budget deficits and debt levels, which have risen above 100 percent of gross domestic product in many countries, including France and Italy, and to create a single insurance scheme deposits for all banks in the euro area to replace the current patchwork of national systems.
The US government provided additional deposit guarantees to ease the US banking crisis triggered by the collapse of Silicon Valley Bank in March.
“You can have an episode of this kind or something worse than that when it is politically infeasible to get that kind of fiscal support,” Gopinath told the FT. “Or you’re dealing with non-banks, in which case it becomes very difficult politically.”