A time for resolve and realism

Speech by Mr Agustín Carstens, General Manager of the BIS, on the occasion of the Bank's Annual General Meeting, Basel, 25 June 2023.

Ladies and gentlemen.

Welcome to the presentation of our 93rd BIS Annual Economic Report.

My remarks will focus on the current state of the global economy, the key risks to the outlook and the roles that all arms of policy must play to meet today's challenges if they are to lay a solid foundation for resilient future growth.

The need for resolute yet realistic policy is a key theme of the Report. Resolve is needed because the global economy is at a critical juncture. For the first time in decades, inflation and financial instability have emerged in tandem. If not addressed promptly, these short-run challenges could entrench themselves as long-run problems. Realism is needed because many of today's short-run challenges reflect an overly expansive view of what macroeconomic policy can achieve. As a result, the long-run challenges are being neglected, with effects that are being felt right now.

High inflation prompts the end of "low-for-long"

To set the stage, let me recap the main economic developments of the past year and the
near-term outlook.

High inflation remained a dominant theme. Admittedly, inflation has come down from last year's multidecade highs. But these were largely the easy gains as commodity prices fell and supply bottlenecks eased. On core inflation, much less progress was made. And in much of the world, price growth in services – typically hard to budge – remains near its peak.

Central banks responded forcefully. The low-for-long era ended, as central banks embarked on the sharpest and most synchronised policy tightening since at least the 1970s. In doing so, they delivered collective monetary restraint that was more than the sum of its parts.

Yet economic activity remained, for the most part, resilient. Growth did slow, but less markedly than many had predicted. And, in many countries, labour market conditions were unexpectedly buoyant, with unemployment rates low by historical standards. This goes some way to explaining the persistence of core inflation.

Emerging market economies weathered the storm. In the past, global monetary policy tightening had tested them. This time, emerging market economies were ready. In many of them, central banks tightened policy earlier and faster than in advanced economies. This bolstered their exchange rates and reinforced the credibility of their monetary policy frameworks in the face of high inflation.

Even as economies continued to grow, serious financial strains emerged. The first signs came from the United Kingdom, where sharply rising bond yields saw pension funds run into trouble. Perhaps more serious and surprising has been the recent turmoil in the banking sector, with several regional banks in the United States closing their doors and a large European G-SIB merging with a competitor.

Once again, the authorities stepped in to limit the damage. Central banks activated or extended liquidity facilities. Governments guaranteed solvency, in some cases by broadening the scope of deposit insurance schemes. These measures calmed markets. But they raised many questions about banking regulation and supervision, as well as the size and scope of safety nets.

Despite these episodes, broader financial conditions tightened less than one might have expected. In part, this reflected a belief by some market participants – incorrect as it turned out – that central banks would blink in the face of higher inflation in order to ease financial strains.

Inflation and financial instability could prevent a soft landing

Against this backdrop, there is an emerging sense that the global economy could achieve a soft, or soft-ish, landing. We all hope it does. But we must be ready to tackle the significant risks that stand in the way. Among those risks, persistently high inflation and financial instability are the two that are most likely to trigger an extended period of sub-par growth, or even a recession.

High inflation could persist. In addition to the inflationary pressures already in the system, new ones could emerge. For the latter, labour markets look to be a key flashpoint. In many countries, workers' purchasing power has fallen substantially, as wage growth has failed to keep pace with inflation. It is conceivable that workers will seek to reverse that, particularly as labour markets are so tight. Firms, having found it easier to raise prices than before the pandemic, may in turn pass these higher costs on. A wage-price spiral could set in.

This story sounds disturbingly like the shift to a high-inflation regime that we analysed in our Annual Economic Report last year. As you may recall, in such a regime, inflation becomes a more salient factor in household and business decision-making, and transitions across regimes become self-reinforcing. Once an inflationary psychology sets in, it is hard to dislodge.

Meanwhile, financial stability risks loom large. Public and private debt levels, and asset prices, are much higher than in past global monetary policy tightening episodes. To date, pandemic-era excess savings and a general lengthening in debt maturities during the low-for-long era have masked the effects of higher rates. But these buffers are rapidly depleting. As they become exhausted, growth could slow more than currently expected.

The resulting financial strains will likely materialise in higher credit losses. Banks would be in the firing line. Historically, it is common for banking stress to emerge as monetary policy tightens. High debt, high asset prices and high inflation amplify the risks. The current episode ticks all the boxes. Although banks' financial positions have improved since the Great Financial Crisis, pockets of vulnerability remain. Low price-to-book ratios suggest a worrying degree of investor scepticism about the long-term prospects of some institutions. And, as recent experience has shown, even small banks can trigger systemic collapses in confidence.

Non-bank financial intermediaries will also be challenged. This sector has grown in leaps and bounds since the Great Financial Crisis. It is also rife with hidden leverage and liquidity mismatches. Business models that worked in the low-for-long era will face stern tests in a
higher-for-longer one.

Weak fiscal positions cloud the picture further. Financial instability, if acute enough, calls for a sovereign backstop. Its adverse effects on economic growth can also cripple fiscal revenues. This would heighten the pressure on already high public debt levels. In turn, doubts about the sovereign's creditworthiness can spark or intensify financial instability.

A shift in policy mindsets is required

How should policymakers respond to these large and unique challenges?

For central banks, the task is clear. They need to restore price stability. A shift to a high-inflation regime would impose enormous costs. No one would benefit. Higher inflation won't boost real wages. It won't deliver growth. It won't bolster financial stability. And any gains from inflating away public debt would be small, risky, temporary and certainly not exploitable.

While central banks' goals are clear, the path is uncertain. The pandemic, in conjunction with broader structural changes, disrupted the usual relationship between interest rates, growth and inflation. With models providing less reliable signposts, judgment is of the essence. Central banks may think that they have done enough, only to find that they need to tighten further. In the meantime, more financial stresses could emerge.

Prudential policies should be deployed more forcefully to buttress the financial system. This would also create more space for monetary policy to tackle inflation. Macroprudential policies should be kept tight, or even tightened further. Research suggests that this can limit the strains that higher interest rates place on the financial sector. And microprudential supervision should be stiffened to remedy the deficiencies that came to light in recent bank failures. Implementation of existing regulations – including Basel III – should be accelerated. Where gaps exist, new regulatory measures may be required.

Fiscal policy must consolidate. Not only for a year or two, but systematically, so as to put unsustainable fiscal trajectories onto a more secure footing. This too would help in the fight against inflation. By limiting the required degree of monetary restraint, it would also bolster financial resilience. And it would provide badly needed buffers that could be deployed against future downturns.

Above all, policy needs to adopt a longer-term focus. High inflation and financial instability were no accident. They were the result of a long journey. Macroeconomic policy had approached the boundaries of what we refer to as the region of stability.

We discuss this concept in more depth in Chapter II. The region of stability refers to the combination of monetary and fiscal policy that delivers sustainable macroeconomic and financial stability. The region evolves and is hard to pin down in real time. Its borders were particularly faint in the low-inflation era leading up to the pandemic. Our sophisticated and outsize financial system has blurred them further. But recent experience leaves no doubt about where we stand.

Several policy implications flow from this analysis. Most directly, monetary and fiscal policies need to operate firmly within the region's boundaries. More fundamentally, a shift in mindset is called for. Macroeconomic policy needs to be realistic about what it can achieve. The journey to the region's boundary reflected in no small part an overly ambitious view of monetary policy's ability to hit narrow inflation goals and of a more general belief that macroeconomic policy could support growth indefinitely, without stoking inflation.

Moving forward, policy needs to be more realistic in its ambitions and more symmetrical over the business cycle. Buffers used in downturns must be rebuilt in recoveries. Unrealistic expectations that have emerged since the Great Financial Crisis and Covid-19 pandemic about the degree and persistence of monetary and fiscal support need to be corrected. Greater attention should be paid to the prominence of financial factors in economic fluctuations, and in policy measures to limit the likelihood and severity of financial crises. As I have said on many previous occasions, governments need to reinvigorate structural reforms to drive long-term growth. There are no short cuts.

A vision for the future financial system

The inflationary outbreak reinforced the imperative for central banks to preserve the public's trust in money. Price stability is an essential part of this. Another is to provide a form of money that keeps pace with technology and the needs of society.

We have explored this theme in several recent Annual Economic Reports. In particular, we examined future forms of money, with a focus on the payments system.

In this year's report, we go a step further and lay out a blueprint for the future financial system. Our vision is of a system that enhances the parts of the system that work well today; and that will enable entirely new financial products tomorrow.

The core of the proposal resembles the arrangements we see today. We still envision a two-tier banking system, with central bank money used for wholesale transactions, and some retail ones, and commercial banks providing the bulk of the money used by households and businesses. Crucially, this arrangement ensures the singleness of money and finality of payments.

But in our vision, money takes a more advanced technological form. In addition to central bank reserves, banknotes and conventional bank deposits, there would be central bank digital currencies and digital commercial bank money. These forms of money would allow for new capabilities, including programmability and composability.

The real benefits, however, would come from linking new monetary arrangements with the broader financial system. To this end, we propose a new financial infrastructure – a unified ledger. The ledger, which in practice would likely resemble a network of networks, would allow for seamless transactions between digital money and other tokenised assets on a single programmable platform. As we discuss in the chapter, this could greatly increase the efficiency of existing financial transactions, deliver instantaneous payment settlement and unlock entirely new economic arrangements.

The vision we propose is ambitious. And it won't be assembled overnight. That is all the more reason for us to get moving. Society rightly expects the monetary and financial system to take full advantage of technological advances to deliver better and more efficient services. If central banks don't take this agenda forward, other, less publicly minded players will fill this space.

Conclusion

Let me conclude.

The global economy is at a critical juncture. Stern challenges must be addressed. But these carry with them significant opportunities: to put macroeconomic policy on a more secure footing; to reinvigorate long-term growth; and to craft a financial system that meets the needs of tomorrow. Capturing these opportunities will take skill, nimbleness and a degree of courage. It will also require the right mindset. The time to obsessively pursue short term growth is past. Monetary policy must now restore price stability. Fiscal policy must consolidate. The opportunities of a future financial system must be grasped. And policymakers of all kinds need to keep their eye on the long term.