Treading through policy normalization: navigating recovery and balancing risks

Published: 22/9/2021

Article by Governor Vujčić for "Views – The EUROFI Magazine", September 2021.

The Covid-19 pandemic has all the elements of a great Hollywood movie. First, there is a threat to end "the world as we know it". Then, there are heroes of the pandemic: scientists who rapidly developed vaccines and the pharmaceutical industry quickly scaling up the production.

And finally, there is a happy ending, as the swift pace of recovery continues to defy expectations throughout the recurring waves of the pandemic, with vaccines propelling economies further as populations in advanced countries are getting close to herd immunity. But vaccination efforts had powerful sidekicks: fiscal and monetary policies, which supported the global economy during the critical period.

Unlike the global financial crisis, when monetary policy was pretty much "the only game in town", a strong fiscal impulse was now concerted with an unprecedented monetary accommodation. Fiscal and monetary policies reinforced each other and fed into a virtuous cycle. Maintaining favourable borrowing conditions by central banks eased the financing of fiscal expansion, while government deficits strengthened the traction of monetary policy. Yet, despite the improving prospects, the recovery remains uneven within countries and across different parts of the world. Downside risks related to new virus variants and limits to vaccine availability, as well as to reluctance to vaccination, still loom large. Most policymakers in advanced economies are therefore in no hurry to wind down their exceptional policies.

For the first time since the start of the pandemic the improving prospects have opened room for discussion about the path to policy normalization. There is a broad consensus on the sequencing of monetary policy normalization: assets purchases will be the first to go away, followed by interest rate increases, with redemptions of government bonds, and maybe even outright sales, gradually reducing the size of the central bank balance sheets only at a later stage. But there is much less of a consensus on the timing and pace of policy normalization.

The central banks of the two largest economic blocs have so far avoided communication on the start of normalization, assuming that the mere discussion would amount to monetary policy tightening. But a batch of central banks from smaller advanced economies, such as Canada or Australia, has already announced tapering or even embarked on it. Even the Bank of Japan has stabilized the size of its balance sheet under the guise of yield curve control.

Some differences in the timing of actions between central banks can be explained by idiosyncratic fundamentals. However, different views on the balance of risks account for the bulk of divergence in central bank communications. The prevailing view in central banks of the largest economic blocs is that the current inflation surge is of a transitory nature.

The stabilization of energy and commodity prices as well as a gradual repair of overstretched production chains and resolution of mismatches in the labour market are considered sufficient to tame the inflationary pressures. Further on, inflation expectations appear to be firmly anchored – regardless of our preferred indicator of future inflation. Finally, erring on monetary policy with inflation on the upside is considered to be less costly than the premature tightening of monetary policy, as we possess adequate tools and knowledge to deal with excess inflation.

The leniency of central banks in major advanced economies towards the buildup of inflationary pressures is not unexpected. Inflation surprised us on the down-side many times over the last decade, so many times that constant inflation undershooting has instilled fear of deflation into the minds of central bankers. But the drivers of inflation may also work in the opposite direction, as we do not have a firm grasp on them.

The pandemic has cracked the globalization process, which may start unwinding disinflationary forces. This may also quickly alter the expectations – we know that consumers, businesses and participants in the financial markets are no better at forecasting inflation than central banks.

Following a prolonged period of exceptionally low interest rates, elevated public and private debts and stretched asset prices may induce surprising market reactions if central banks get forced into strong action.

Finally, recent tweaks to monetary policy strategies may also complicate matters, as new policy reaction functions are not yet obvious to markets, potentially forcing central bank actions even if there was no need for any.

To conclude, we need to tread carefully through the recovery, constantly reevaluating the balance of risks and avoiding strategies that may force excessive reactions somewhere down the road.