DMD Kenji Okamura Remarks at the Three Seas Initiative (3SI) - "Monetary Policy in a New European Reality"
June 10, 2022
Introduction
Thank you very much to the National Bank of Poland for holding this conference, and to Governor Glapiński for the kind remarks.
Before I begin, I would like to offer my sincere apologies for not being able to attend in person. My flight took off as usual, but flew back to Washington due to reasons beyond my control. I had been very much looking forward to representing the Fund in person, but I am grateful to still be able to do so virtually.
I greatly appreciate this opportunity to discuss monetary policy in the Three Seas countries. Because we all know that the waters are choppy waters, and more rough weather lies ahead. Central bankers will need all their navigational skills and tools at the ready to get safely to shore.
As the tightening cycle takes hold and policymakers look to what’s next, let’s briefly take stock. We arrive at this moment after three decades of remarkable economic progress, driven by cross-border integration.
The emerging markets of this region have made substantial progress toward Western European income levels. Many of them are in the Euro Area, or in the process of joining. And the region’s recovery from the pandemic-induced recession has been impressively rapid. For this, your quick provision of monetary support—along with fiscal measures—deserves much credit.
Today, I’d like to take a closer look at regional central banks’ responses to the pandemic, particularly Asset Purchase Programs (APPs). And then I’ll review drivers of the current higher inflation environment and how central banks should respond in this moment. Finally, I will speak to medium-term challenges.
Central bank actions during the pandemic
I doubt any of us will ever forget the first few stormy weeks of the pandemic: markets in turmoil, economic activity stopped in its tracks, bond spreads spiking, and investors off-loading local currency instruments.
Central banks acted quickly to avoid another Great Depression, reducing policy rates to support economic activity. Some acted to address strained liquidity in domestic bond markets, purchasing local-currency bonds. Central banks in Croatia, Hungary, Poland, Romania, Serbia, and Turkey all engaged in these asset purchase programs.
These APPs were different from the quantitative easing used in many advanced economies. Purchases were generally limited to the initial weeks of the pandemic. They focused on the mitigation of market dysfunction and repair of monetary policy transmission mechanisms—not necessarily on providing additional policy stimulus.
Importantly, these APPs were implemented without creating noticeable currency pressures in emerging markets. That’s in contrast to similar previous actions by emerging market central banks, which were often associated with macroeconomic instability.
The strong institutional frameworks—including EU membership in most cases—and track records of these central banks appear to have mitigated such concerns and contributed to the success of these measures. A very encouraging outcome!
The transition to a higher inflationary environment
Despite contained currency pressures, some increase in headline inflation was anticipated in 2021 due to the commodity price recovery and other base effects. But the strength and persistence of inflation caught most observers by surprise – reaching 5 percent in the Euro Area by the end of 2021 and 8 percent in emerging Europe, excluding Russia and Turkey.
Digging deeper, in central Europe, we noticed a divergence in data. Traditional measures of core inflation, such as inflation excluding food and energy prices, were somewhat elevated in early 2021. But more median-based measures of inflation – which exclude the largest and smallest price movements in the basket of goods and services – showed relative stability, suggesting lower underlying inflationary pressures.
We attributed the divergence to supply chain disruptions, which had an outsized impact on overall inflation despite only impacting a relatively narrow range of goods. So initially, it seemed appropriate to look through externally and supply-driven price pressures.
However, over the course of 2021, the different measures of core inflation converged at higher levels in the Three Seas countries. This signaled that underlying price pressures were becoming more widespread and linked to demand pressures. Labor markets became tighter as well, and the risk of second-round effects rose. As a result, central banks began increasing policy rates by the fall of 2021.
Here, one big question hangs in the air: why were central banks, the IMF, and so many others, so far off in their initial forecasts?
We all underestimated both commodity price increases and the recovery in demand, globally and in the region. In the April 2021 World Economic Outlook, the IMF projected average economic growth in emerging Europe that year at 4.4 percent, but growth outperformed significantly at 6.7 percent.
This was due to multiple factors, including a rapid reduction in household saving rates, continuing fiscal and monetary policy support, and the diminishing effect of successive COVID waves on both demand and supply—thanks in large part to vaccines.
More favorable pre-pandemic conditions in the region also helped. Many economies were operating at or above potential and had shallower recessions than in Western Europe. Rapid recoveries closed output gaps quickly and labor markets remained tight, with rapid wage growth and low unemployment.
Policy response to current challenges
Then, before the pandemic-driven storm had fully cleared, came Russia’s invasion of Ukraine. The implications of the war are significant for the region. In addition to the largest refugee crisis since the Second World War, the accompanying supply shock means a massive increase in prices and reduction in aggregate demand.
We have raised our inflation projections for this year, to 5.3 percent for the Euro Area and 9.3 percent for emerging Europe excluding Russia and Turkey. At the same time, we marked down projected growth in the Euro Area from 3.9 to 2.8 percent. For the emerging countries, the drop is from 4.3 to 2.7 percent.
To summarize: growth is slowing, but inflation is increasing in a broad-based manner, although still mainly due to food and energy price shocks.
That brings us to the next big question: What can central banks do about large supply shocks that are significant drivers of the ongoing inflation surge?
Central banks cannot do much about the supply shock per se.
But we also cannot wait for supply pressures to somehow ease over time.
For one, the duration of the events behind those shocks is uncertain. And the sheer size of the energy price shock has helped drive inflation far above target in many countries, even after some reductions in indirect taxes. All this could destabilize inflation expectations and potentially feed an inflationary spiral.
Central banks should also react because they are not dealing with the effects of a textbook supply shock. The positive output gaps delivered by strong recoveries in emerging Europe suggest a demand driver is also involved. And central banks have a natural mission concerning demand drivers of inflation: to try to engineer the soft landing.
Yet another factor is the global nature of the inflation rise and some of its drivers. The external aspect of the drivers is obvious when we think of oil and gas imports. But the global scale of the recovery in demand is important as well.
If only a few countries were experiencing high demand, their current accounts would weaken substantially, taking some pressure off prices. But demand has been pushing up at the same time in a large part of the global economy, shutting off this escape valve.
With central banks around the world in tightening mode, lagging behind the trend could mean capital outflows and currency depreciation. Moreover, if supply drivers of inflation persist, policymakers will face two choices: more painful tightening or a longer period of inflation overshooting.
So even though tightening always implies some output losses, in order to combat inflation, monetary policymakers have little option but to tighten. Timely and clear communication will be essential to reduce the harms of this tradeoff.
Driving forces will play out somewhat differently in each jurisdiction and over time. Yes, with inflation running far above targets despite diminishing pressure on labor markets from stagnating activity, monetary policy should broadly maintain the course of tightening. But its pace should vary with economic circumstances. Where inflation expectations could de-anchor, tightening should proceed faster.
Of course, high uncertainty around the inflation outlook remains. This calls for the pace of monetary policy tightening to react flexibly based on incoming data. Faster tightening cannot be ruled out if inflation continues to surprise on the upside, wage pressures build, and inflation expectations rise.
However, if the outlook for activity and medium-term inflation weakens, the pace of tightening could be slowed. Communication will be important, including to explain the effects on inflation of the eventual reversal of temporary cuts in indirect taxes.
Dealing with inflation is critical to protect the spending power of those living on fixed incomes and other vulnerable people. The necessary tightening will be painful for many of them.
So, we advise policymakers to provide targeted, direct support to those most affected and vulnerable.
To be clear: our recommendations are derived from a baseline scenario that does not include the “stagflationary” shock of shutting off Russian gas to all of Europe. With widely differing impacts by country, policy responses to that scenario would need to be quick and tailored. Central banks should prepare contingency plans.
Medium-term challenges and conclusion
Now, let me highlight some medium-term challenges for monetary policy.
First, increased public debt—and in some cases high gross financing needs—exacerbated by the necessary loans countries worldwide took to protect their people from the economic consequences of the pandemic and war in Ukraine. This could bring pressure on some central banks to keep policies loose.
Second, energy price volatility. Even after the war ends, energy prices may remain higher than before it started. And they will continue to fluctuate, even as the price of fossil fuels must steadily rise to save our climate. This will require central banks to think about their strategies for maintaining broad price stability over longer time horizons than usual.
Third, the risk of geoeconomic fragmentation. It could reverse some of the forces that enabled low inflation amid low equilibrium real interest rates before the pandemic. Commercial and financial globalization have contributed to price stability and low equilibrium interest rates—and are now at risk of retreat. The result could be an increase in neutral interest rates that will be difficult to identify and react to in real time.
To meet these challenges, we need strong, independent central banks! They should follow a careful and rigorous approach to analyzing data and examining facts—and work to further strengthen internal processes and communication with the public and markets.
I have no doubt that the central banks represented at this conference are up to these challenges. And the IMF is here to support you.
Our full range of tools, including granular, real-time, policy advice, capacity development, and our one trillion dollar lending capacity, are at your service. I hope this conference will further deepen our understanding about how we can further improve these tools and make them even more responsive to your needs.
While we cannot say for sure when the rain clouds will blow away from the Three Seas, one thing is clear: we will be better off if we weather the storm together.
Thank you.