Central banks should try to minimize an economic downturn if possible, but must prioritize taming inflation above any other goal, the Bank for International Settlements has urged.
If they don’t bring inflation under control, they run the risk that the current sky-high rates of price rises become entrenched, according to strategists at BIS, which coordinates monetary policy across the world’s central banks.
“The COVID recession and subsequent expansion … has led to higher inflationary pressures alongside elevated financial vulnerabilities,” BIS strategists wrote in an annual report published Monday. “This combination is historically unprecedented.”
During the coronavirus pandemic, economies slowed as lockdowns and other impacts hit consumer spending, supply chains and industrial production. Once restrictions were lifted and economies opened up again, house prices, stock markets, and wages all soared in an environment of low interest rates, high fiscal spending and pent-up demand.
In May, inflation hit a four-decade high of 8.6% in the US and reached a record of 8.1% in the eurozone. In response, the Federal Reserve raised interest rates by 75 basis points, while the European Central Bank plans to make its first rate hike in 11 years in July.
In the US, many investors are worried about a “hard landing” scenario, where the Fed increases rates at too fast a pace and causes a recession or a stock market crash. Uncertainty about the path and outcome of its monetary tightening has driven volatility in stock markets.
Central banks worldwide are weighing the balance between focusing on battling inflation — which would call for hard and fast interest rate increases — or on preventing a recession, which would likely mean a softer approach.
“The new inflationary environment has changed the balance of risks,” BIS strategists said. “Central banks have not faced this challenge for decades.”
Failing to act now would mean that rising prices become a permanent feature of developed economies, which would likely necessitate aggressive interest rate rises in the future, the BIS added.
“Delaying the necessary adjustment heightens the likelihood that even larger and more costly future policy rate increases will be required, particularly if inflation becomes entrenched,” its strategists wrote.
Fed Chair Jerome Powell has warned that a short-term economic downturn may be the only way to control inflation.
“The process of getting inflation down to 2% will also include some pain,” Powell said last month. “But ultimately, the most painful thing would be if we were to fail to deal with it and inflation were to get entrenched.”
Read more: A portfolio manager at billionaire investor Mario Gabelli’s $41 billion firm says to buy these 27 stocks that have the pricing power to deliver returns as inflation soars
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