The International Monetary Fund (IMF) has advised central banks in Europe to sustain interest rate hike until inflation is defeated.
In a report entitled: Working in Concert to Defeat Inflation, Director, European Department, IMF, Alfred Kammer said policymakers were facing a multifaceted challenge: to defeat inflation, while safeguarding financial stability and sustaining the recovery.
He said success at these efforts would require tighter macroeconomic policies tailored to changing conditions, strong financial supervision and regulation, and bold supply-side reforms.
He said tighter fiscal policy would help central banks meet their inflation objectives at lower policy rates and lower public debt service costs while reducing financial stability and fragmentation risks.
“To address today’s high inflation, requires tighter monetary policy for longer, until inflation is on a firm path toward target. This will help avoid more drastic and costly adjustments later. Governments should take advantage of buoyant tax revenues and falling energy prices to pursue more ambitious fiscal consolidation to support the disinflation effort. This would allow central banks to fight against inflation with lower interest rates, and restore depleted fiscal space,” he added.
Continuing he said: “Our message is clear: monetary policy cannot do the job alone and policymakers should work in concert. While declining energy prices are helping to lower headline inflation, this will not be enough to bring inflation back to targets. Headline inflation for 2023 is expected to remain high with 5.6 percent in advanced economies and 11.7 per cent in emerging economies. And core inflation remains high and persistent.”
Kammer said whenever there is a clear risk that inflation could be more persistent than assumed, it is better for central banks to assume that inflation is in fact persistent and raise rates accordingly.
“Central banks should thus maintain a tight monetary policy until core inflation is unambiguously on a downward path back to central bank inflation targets,” he advised.
This, he explains, means there is more ground to cover for some in terms of the monetary policy tightening cycle to provide a needed contractionary stance, depressing demand.
“Failure to do so could entrench high inflation and force central banks to tighten much more forcefully later, pushing the economy likely into a sharp recession. It is this—much worse—outcome which we want to avoid,” Kammer said.
For the European Central Bank, this implies that rates still have some way to go.
“Under our baseline projection of April, which assumes a terminal rate of 3.75 per cent, inflation is projected to converge to target only in mid-2025. That is too long a period for inflation to stay meaningfully above target,” he said.
He asked central banks in emerging market economies to stand ready to tighten further, where real interest rates are low, labor markets are tight, and underlying inflation is sticky.
He said elevated financial risks during a tightening cycle require continued monitoring, close supervision, contingency planning, and faithful and timely implementation of Basel III.
He advised that in jurisdictions where banks are experiencing temporarily high profits, countercyclical capital buffers could be tightened as a step towards positive neutral rates for these buffers.
