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Central banks must accept the “inconvenient truth” that they may have to tolerate a prolonged period of inflation above their 2% target to avert a financial crisis, the IMF’s deputy chief has warned.
Gita Gopinath, speaking at the European Central Bank’s annual conference in Sintra, Portugal, said policymakers risk facing a difficult choice between solving a future financial crash in heavily indebted countries or raising borrowing costs to the point that stubborn inflation is contained.
“We’re not there yet, but it’s a possibility,” Gopinath told the Financial Times ahead of her speech. “In this environment, central banks could adjust their response function and say, ‘Okay, maybe we can tolerate higher inflation longer.'”
The high debt levels of many European governments leave them vulnerable to another financial crisis, said Gopinath, who was promoted to deputy chief executive from the IMF’s chief economist last year.
“We are entering a phase where we have to recognize that inflation is taking too long to reach the target – that’s my first uncomfortable truth – and that means we risk inflation becoming entrenched,” he said Gopinath.
“If governments lack 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.
However, she added that there would need to be a “high bar” before leading central banks would accept inflation staying above their 2% target for longer, as this could lead to even stronger price growth, as seen in the 1960s in France was the case in the United States.
Financial stress in the eurozone “can also have multiple regional implications, with.” [interest rate] “Spreads are widening more in some highly indebted economies,” and this could “intensify other vulnerabilities stemming from household debt and a large share of adjustable-rate mortgages in some countries,” she said.
Gopinath said in her speech that the ECB and other central banks “should be prepared to react vigorously to signs of persistent inflation,” even if it translates into a “much sharper slowdown” in labor markets.
The ECB has already raised its key deposit rate at an unprecedented pace from minus 0.5 percent last year to 3.5 percent earlier this month, signaling that another quarter-point hike in July is “very likely”.
Governments could also help fight inflation by reducing deficit-financed spending to lower demand and lower the amount the ECB has to raise rates by, she said.
“Given the economic conditions we have, both high inflation and record high debt, both would call for fiscal tightening,” she said. “If you look at the projected budget deficits of many G7 countries, they seem too high for too long.”
The ECB launched a bond-buying program called the “Transmission Protection Instrument” to prevent rising borrowing costs from triggering another sovereign debt crisis in the eurozone. But that’s untested and Gopinath said more could be done to prepare for potential financial strains.
She called on EU governments to agree new rules to reduce their budget deficits and debt levels, which have soared to over 100 percent of gross domestic product in many countries including France and Italy, and create a unified deposit guarantee scheme for all eurozone banks around the current one to replace patchwork 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.
“There could be an incident like this or more serious where it’s not politically feasible to get that kind of financial support,” Gopinath told the Financial Times. “Or you are dealing with non-banks, then it becomes very difficult politically.”