Panel participation Deglobalisation and Fragmentation: Mid Term Challenges for Central Banks

We haven’t talked a lot about negative supply shocks. And my question for the panel, and I’m going to start by alphabetical order: it does seem that the world has been seeing more frequent supply shocks. I would say that that may be a new period for the world economy, because we also have more fragmentation, so they have more geopolitical events. So in that situation, how do you do monetary policy? How do you balance these shocks vis-à-vis your policy objectives?

Thanks for the invitation. And I agree with you that the list of adverse supply shocks is lengthening. COVID, Ukraine, Iran, you can add climate and demographics along with that. They’re not all negative. I mean, the AI shock, tech shock, maybe the other way, it’s a supply shock still. But then the adverse supply shock is the central bankers’ nightmare, right? Because it pushes inflation up and it pushes activity down and causes you real challenges in managing that. I’d say, since I get to go first, I’ll set out a framework rather than a specific discussion on Australia. I put it into three broad buckets. So firstly, we need to work out how to analyse these shocks. That’s not as easy as it first seems. You know, we all had to become epidemiologists during COVID and we’re not really epidemiologists by training. Now having to become energy experts, understanding the nature of the shock is not something that necessarily we as central banks are expert at, but we need to do so. Our models are much better at describing demand than supply, 88 words for snow and none for rain, as it were, and identifying the difference between supply and demand shocks can be difficult, so that’s the analytical challenge. In terms of designing policy, you can’t do much to affect the first-round effects on inflation, but you do need to assess what the impact over the medium term will be, and you do need to bear in mind that it can get built into inflation expectations, which again as I say, happened in the 1970s, we can’t go back there.

Starting conditions matter a lot. In Australia, we went into the Iran shock already running quite hot, and that created some challenges. If you do have capital flow, exchange rate issues as well, those are particularly difficult. You’ve got to explore the flexibility in your flexible inflation targeting regime, but you can’t do that so far that you actually let inflation expectations get out of control. Final point, communications. Supply shocks are a hard sell to the public, inflation is never going to be higher, activity is going to be lower, we’re going to be poorer. There’s not much upside news in that story, but you don’t get a lot of public support necessarily for that. That’s harder at a time when we’ve had high inflation already, and people are already a bit resentful about that, so you need to be clear and direct with people, restate the importance of stabilising inflation. You need to be very clear what you can’t do, because people are maybe thinking that monetary policy can solve everything, and you need rock solid support from governments at a time when you’re going to be making hard decisions. That’s actually quite a tough list in terms of setting monetary policy and lists that we haven’t always met in the last period.

(Panel discussion)

Just on this point about pre-emption. It’s easy to say that it’s pre-emptive, so long as you know what you’re pre-empting against. And my mind goes back to Brexit and the challenges that the Bank of England faced when that occurred. It looked like a pretty classical supply shock. However, that’s not how it played out. The adverse supply effects took a decade to come through the UK. It will be dealing with them now, we thought they were going to come through pretty quickly. Some of the more powerful adverse supply shocks that we are all experiencing now, namely, with the exception of the US, are not these things out of the clear blue sky, but the grinding lower effects of weaker productivity growth, and the lack of innovation and there’s other things which at least Australia are probably still the dominant policy challenge, rather than something who comes today and goes tomorrow.

Now we can talk about a second aspect of what this type of supply shock may cause for an economy which have financial stability risks. So if you have supply shock is big enough, and we feel like is going to affect certain long-term expectations for inflation, you may want to tighten, but you may be causing some, or may have some undesirable effects. In the case of Australia, to think about the whole discussion about household balance sheets that may be hurt because of their level of indebtedness. So how do you see financial stability in this world of supply shocks and, and in the particular case of Australia, how do you deal with those?

At the moment, I wouldn’t actually say in Australia that the potential adverse effects of Iran is to be specific on financial stability in Australia is not our biggest policy challenge. To be frank, households have rebuilt their balance sheets and the firms over the course of the last few years. The banking system in Australia is almost comically well-capitalised and highly liquid. We do have a large pension system which are heavily invested in the US. And that issue, I suppose, could come to light. I think, if I may, the more substantial financial stability risk that could arise here comes from this broad question of fragmentation, where I think this is a big and growing issue, increasingly separate pools of capital that find it hard to allocate across different countries, separate payment systems, walled gardens, regulatory competition and divergence. And I think you’re probably more likely to see sanctions and cross-border contagion, provision and liquidity resolution. We’ve worked so hard over the past decade or two to try and put in place imperfect, but more effective than before, tools for dealing with that across corporate contagion effects and in the world of fragmentation, I think the biggest risk for all of this is that some of those efforts, get into reverse.

It may be too much to ask for central bank to deal with all the financial stability issues. Maybe there’s in this world you need more coordination of fiscal policy, industrial policy, regulation. What’s the role of these other policies?

Well, I think here you have to be humble. I mean, it was interesting in the UK for a period, people thought, wow, the Bank of England can solve everything. And many of us, over the years, have been asked to do more and more. And actually what I think, particularly in this circumstance, and colleagues on the panel said have already, we have to stick to our knitting as the UK would say. We have to be clear that what monetary policy can do is anchor inflation and inflation expectations. It can’t deal with the distributional goals. It can’t make you richer, or you not richer, it can’t replace lost supply. Again, there’s not a lot of good news in some of this when it comes to monetary policy communication, that the things that monetary policy cannot do in these spaces far outweigh the things that we can.

(Panel discussion)

No, thank you very much. Actually, I have a follow up question, Are you truly concerned about in NFBI? I mean, like we had just a discussion last week at the BIS, and they asked me to presentation on private markets, the size of the sector, and the links to this. I understand that, because they are not, it’s not a public market, and if you don’t have an exit for that capital, through IPO or through other ways. You may not know the price of things. You may not know the true risk, and then you need to pay attention. But I don’t know if any of you are actually very concerned, or is just part of a broad agenda that you need to know?

(Panel discussion)

I think it is important to look at the risks. I don’t know if anybody else has a view?

Well, as the veteran of the LDR crisis in the UK, I can tell you that the view that NBFI’s can’t blow you up is just wrong. You know, that all came out of a clear blue sky for the UK financial system, and the UK Government is still paying a premium on its debt for that error. [inaudible]. The problem is, you’re looking for a needle in the haystack. And so that’s the challenge.

No, I agree. There’s a big challenge. And here we are. We are kind of hitting the issue of it’s a societal issue. People take risks. So if you curb risk in one side, these risks are going to appear in the other side. And there is something quite healthy about taking risks. By taking risks, how you create things and economic activity flourish. One should also think about how to deal with firms or people that take risks that did not succeed. And then you come back to structure polls, how you do with bankruptcy courts, the ability of people to kind of get back in their feet, because we have this relation that allowed people who took risks that didn’t work out to come back. So I think here is another place where structural policies matter a lot.

(Panel discussion)

if your point is in the developed world, one of our biggest challenges outside the US is low productivity growth. And it may just be the case that low productivity growth is a function of an unwillingness to take almost any conscious risk than you must be right. Whether financial regulation is the primary cause of that, I’m not sure. There’s a whole political discourse about this topic, isn’t there, but certainly we all need to find ways of generating innovation in our economy. Some of us have done it well. Many of us have not yet done it well. If that was your point, I think that has considerable merit.