Where are we on the journey towards price stability?

Speech by Mr Agustín Carstens, General Manager of the BIS, at the Statistisch-Volkswirtschaftlichen Gesellschaft (SVG), Basel, 22 January 2024.

It is a great pleasure to be here and to reflect on the inflections the new year may bring to the macroeconomic policy course we are on.

Over the past two years, central banks have embarked on the largest and most synchronised global monetary policy tightening in a generation.

Now the end of this exceptional tightening is in sight. Most central banks have signalled that their policy rates may have reached their peak. In Switzerland, rates have been on hold since June last year. Central banks in some emerging market economies have already lowered them.

Meanwhile, economic activity has remained surprisingly resilient, bolstering confidence that economies might be posed for a soft – or at least soft-ish – landing scenario.

If that is true, the fight against inflation has come at a remarkably small cost in terms of lower GDP growth or higher unemployment. Had you told most economists in 2021 that key central banks would raise their policy rates by 5 percentage points, they would have predicted a sizeable hit to economic activity, or even a recession. And, given already high debt levels and the vulnerabilities accumulated during the low-for-long era, it would not have been too far-fetched to also expect a significant increase in delinquencies and bankruptcies, or even a financial crisis.

Fortunately, such dire predictions have not materialised so far. But will this resilience continue?

At this juncture, Switzerland's experience can be an encouraging tale. Inflation has already declined below target, while economic activity has remained resilient. Headline inflation stands at 1.7%, half the peak it had reached in 2022. Real GDP growth did slow, especially in the latter part of 2023. Still, at 0.4% in the third quarter, it fared well against expectations and relative to the performance of its peers.

To be sure, this is not the end of the journey. As the Swiss National Bank (SNB) noted in its most recent monetary policy assessment, inflation is likely to rise again somewhat in the coming months due to higher electricity prices and rents, as well as the rise in VAT.¹ But the progress in stemming inflationary pressures is clearly there. 

The SNB's decision to raise policy rates in mid-2022, when inflation was at just 3%, played an important role in securing this outcome. So did its willingness to let the exchange rate appreciate.

The experience of the Swiss economy is also tied to robust fundamentals, such as a healthy fiscal position and strong competitiveness – attributes that are not equally shared by other countries. Nevertheless, the Swiss experience can still serve as a valuable guide for others, showing how prudent and credible policy actions can help stir economies out of the post-pandemic inflation surge without major damage to the economy.  

Now let me turn to the global picture. My remarks today will touch on what underpins confidence that the hiking cycle across the globe may have peaked and that a soft landing is within reach, as well as on what might still go wrong.

I will structure my talk in three parts.

First, what are signposts that we should observe over the next six to nine months to justify the belief that a soft-landing scenario is within reach?

Second, what do I see as the most significant risks to this path?

Third, what type of corrective actions might be needed if the soft-landing scenario does not come to pass?

Let me start by describing the four signposts that would confirm we are on the right course.

First, and most importantly, inflation continues to come down.

We have seen much progress already. Just as the rise in inflation was a global phenomenon, its decline has also been similar across countries. Advanced economies started 2023 with inflation averaging 7.5%. Today their average inflation is 3.2%. In emerging markets, excluding a couple of outliers, average inflation dropped from 8.1% to 4.1% over the same period.

Some of the decline reflects lower commodity prices after the very rapid rises seen in 2022 and the post-pandemic normalisation of supply chains. Although welcome, these are easy "one-off" gains.

Beyond these easy gains, more telling are the recent improvements in the "stickier" inflation categories, such as services. In major advanced economies, year-on-year price growth in services excluding housing exceeded 5% on average at the beginning of 2023 but has recently come down to about 4%. In major emerging markets, it stood at 9% in early 2023 but fell below 7% towards the end of the year. Disinflation is becoming fairly broad-based.

Crucially, so far we are not seeing evidence of wage-price spirals unfolding. This indicates that households and businesses have not yet started to build an assumption of ongoing high inflation into their consumption, investment or wage-bargaining decisions.

This is, in no small part, because monetary policy is doing its job. As discussed in a recent BIS Bulletin, if central banks had not resolutely tightened monetary policy in response to the inflation surge, we would have confronted a much higher risk of entrenched and persistent inflationary dynamics.²

But while the trend reduction in inflation is good, lower inflation is not low inflation. Inflation is still above central bank targets in most countries and needs to fall further. Financial markets and professional forecasters suggest that it will, and by the middle of 2025, if not earlier, central bank inflation targets will be within reach.

These expectations are partly underpinned by the notion that monetary policy operates with lags. Therefore, even if central banks were to end the hiking cycle today, the cumulative monetary tightening since the pandemic would still exercise downward pressures on inflation for several months to come. We would then see a continued, steady decline in inflation, including in the services sectors. 

Second, economic growth rates level off.

Global growth has slowed further in 2023. The rebound in China has been weaker than many had hoped. And Europe skirted recession. Admittedly, the United States has been an important exception. But there, too, activity is expected to soften soon as pandemic-era excess savings are depleted.

Some of the growth slowdown reflects a natural "payback" for the very rapid growth rates seen in 2021–22. At the same time, demand for goods declined as consumption rotated back to services. Higher energy costs were a further headwind to manufacturing and services activity alike. And importantly, the monetary tightening has materially lifted interest rates – nominal and real – and, as intended, weighed on aggregate demand.

Nevertheless, if all goes according to plan, the slowdown in growth will be shallow and short-lived. Once inflation returns to target, and central banks are able to ease up on the brakes, growth rates should return to their long-run potential levels.

Third, labour markets loosen.

A big puzzle over the post-pandemic period is that labour markets in many countries have remained tight despite weakening GDP growth. Unemployment rates continue to hover around historical lows.

As discussed in a recent BIS Quarterly Review article, the pandemic disrupted labour supply and distorted labour demand.³ On the path to a soft landing, the pandemic legacy would not be long-lasting. Changes in work preferences in the direction of lower labour force participation and fewer hours worked would be temporary, and labour hoarding by firms startled by the difficulty in hiring workers back during the recovery would dissipate. As a result, job vacancy rates would continue to decline.

In the near term, one would expect Okun's law to reassert itself, so that the slowdown in economic activity should be accompanied by a rise in unemployment. But, as long as growth remains reasonably firm, the deterioration in labour market conditions should be modest. Most countries will be left with labour market outcomes that, from a historical perspective, look more than satisfactory.

Fourth, productivity growth improves.

Mechanically, the recent combination of strong labour markets and low GDP growth has implied weak labour productivity growth. Output per hour has stagnated even as employment has expanded robustly.

As labour markets normalise and growth rates converge to potential levels, this pattern should reverse itself. Faster productivity growth would make it feasible for workers to make up for the reduction in real wages many experienced over the past two years, without a significant squeeze in corporate profits. This, in turn, would reduce the likelihood of wage-price spirals emerging.

So, in sum, the path in the next six to nine months should be marked by a continued reduction in inflation, subdued yet stable growth, a modest weakening of the labour market and a gradual pickup in productivity growth. And, eventually, inflation would be back to target and growth rates would converge to potential.

What could derail this proverbial soft landing?

My main concern is that inflation rates may not return to target levels as quickly and as firmly as most forecasters expect.

As has been said many times, the last mile could still be the hardest. 

Services price growth, in particular, may continue to be much higher than goods price growth for some time. The price of services vis-à-vis goods collapsed during the pandemic.

Based on an illustrative exercise by BIS staff, the higher services price growth required to restore pre-pandemic relative price trends would imply inflation rates roughly 1 percentage point above inflation targets over the next three years.

It is in this context that, while central banks have done their job by tightening monetary policy and restraining aggregate demand, the same cannot be said for fiscal policy.

Fiscal deficits, which justifiably widened during the Covid-19 pandemic, have yet to return to pre-pandemic levels – which were already very large. This is adding to aggregate demand, which does not help, given that broader macroeconomic conditions are more resilient than anticipated.

Furthermore, as discussed, it is quite reasonable to expect that real wages will try to catch up. If productivity does not pick up and rather goes back to the sluggish pre-pandemic trends, it will imply higher unit labour cost for a given level of wage inflation, raising the risk of further price pressures.

Upward pressure on prices could also re-emerge if geopolitical tensions continue to rise, with negative repercussions for commodity markets and global trade flows. This risk is vividly illustrated by the ongoing disruptions to global shipping in the Red Sea, which resulted in a doubling of container shipping costs since December. Recall that the bounce-back in aggregate supply thanks to normalisation of global supply chains has gone hand in hand with disinflation. More broadly, in August 2022 in Jackson Hole, I spoke of a number of secular forces that could lead to structurally higher inflationary pressures going forwards.⁴ In addition to geopolitics, I mentioned deglobalisation and demographics limiting the responsiveness of aggregate supply to aggregate demand. If anything, those forces have intensified since then.

Finally, another key risk to the inflation outlook is that financial markets may start to price in sharper and faster monetary easing than warranted. As long-term rates have fallen recently, stock indices have rebounded, some hitting all-time highs. House prices have also picked up again in several economies and are not far from their peaks. This would lead to a premature easing of financial conditions that could rekindle inflationary pressures.

Besides the risks to inflation, we need to envisage the possibility that the present soft patch in growth could continue, or even intensify. As previously mentioned, monetary policy operates with lags. The full impact of higher interest rates is thus still to be felt and may prove stronger than anticipated.

Financial amplification channels are particularly hard to predict. In several countries, borrowers have been largely shielded so far from the effects of higher interest rates because of fixed-rate loans. But pressures on borrowers will mount when loans reprice and debt gets refinanced. Indeed, borrowers face a "wall of maturity" in the next few years. The impact on household consumption and firm revenues could be stronger than anticipated, potentially jeopardising the economic resilience that we have experienced so far.

Borrowers' distress will also pose challenges for the financial system via higher delinquency rates, thus compounding the risks to the economic outlook. Indeed, the question is not whether there will be credit losses but rather how large they will be and how well the financial system will be able to take them. Lower growth could help bring inflation down faster. But that too could take time. In the meantime, central banks could face pressure to ease policy, even before the battle against inflation has been decisively won.

Let me now turn to what all this means for policy.

For monetary policy, there can be no let-up on the fight against inflation. The key priority remains to steadily guide inflation back to target levels.

As discussed, there are various forces that could keep adding pressure on inflation – loose fiscal policy, the catch-up in real wages, waning disinflationary factors, and possibly a premature easing of financial conditions.

To be abundantly clear, I see no appetite that central banks would accommodate these pressures. Central banks will do their job and remain vigilant. In fact, if inflation does not continue on its steady decline to target, central banks may decide to keep interest rates as high as needed or even do more.

In this context, it is worth underscoring the challenges that renewed supply shocks would pose – a relevant risk against the backdrop of geopolitical tensions, challenges posed by the green transition, and adverse demographic forces.

In normal times, when inflation hovers around target, central banks would generally be able to see through the temporary increase in inflation triggered by adverse supply shocks. But these are not normal times. After a prolonged period of elevated inflation, letting inflation surge again – even if on the back of a temporary shock – would be a very risky strategy. 

Turning to fiscal policy, the time has come to tighten belts.

This is not a new message. But we have reached the point where fiscal consolidation is an imperative. Public debt levels are at record highs and fiscal deficits remain way too large in many countries despite the resilience of the economic cycle. Absent fiscal consolidation and considering age-related spending pressures, public debt levels in both advanced and emerging market economies would grow exponentially, as illustrated in the BIS Annual Economic Report 2023.⁵

Additional fiscal challenges arise from the spending needs related to geopolitical tensions and the green transition, as well as from a possible increase in equilibrium real interest rates. Reducing fiscal deficits is thus essential to preserve macroeconomic stability in the medium term and would also support the ongoing process of disinflation.

Policymakers must also remain vigilant to potential financial stability risks. The high level of interest rates will continue to put pressure on borrowers. And there is also a risk of market dysfunction, especially if demand for liquidity soars as distressed loans rise.

So far, financial conditions have proved remarkably resilient, notwithstanding the episodes we witnessed in late 2022 and early 2023 in several advanced economies.

The substantial improvements in loss-absorption capacity for the banking sector since the 2008 financial crisis have clearly played an important role in bolstering resilience and helped ensure that the period of banking stress we saw last year was contained to a small number of institutions.

Timely and forceful deployment of a number of crisis management tools also helped curb systemic risks. This included actions by central banks. For instance, the Federal Reserve established the Bank Term Funding Program, offering loans to banks that pledged qualifying government securities, valued at par and thus above market value. This complemented lending through the Federal Reserve's discount window. In Switzerland, the central bank pledged significant liquidity support to back the emergency takeover of Credit Suisse.

That said, the surprisingly buoyant activity and strong labour markets, and perhaps even luck, have also played a role. As the economy cools, it would be complacent to rely on this continuing to be the case. It is essential that supervisors and regulators are ready to take prompt and preventative action to preserve financial resiliency when signs of distress emerge. Such early actions can minimise the likelihood that emergency measures, like those deployed in March 2023, will be required.

Last but not least, policymakers should re-energise the structural reform agenda. This is key to ease the burden placed on monetary and fiscal policy, which are too often called on to provide economic stimulus in a context of persistently sluggish productivity growth. Achieving higher and sustainable growth can only be accomplished by boosting productive potential through measures enhancing the supply side and boosting innovation. This requires renewed efforts to design and implement structural reforms in product and labour markets, which have slowed considerably over the past two decades.

To conclude, I think recent developments allow us to look at the future with cautious optimism. Decisive action by central banks has prevented inflation dynamics from becoming entrenched, while economic activity and financial stability have proved to be remarkably resilient.

But the job is not complete yet, and considerable risks remain. The success we have had so far must not breed complacency. Policymakers must heed the signposts and remain steadfast in their commitment to completing the disinflation journey while reinvigorating efforts to ensure sustainable fiscal paths and lift productivity growth.

¹       Swiss National Bank, Monetary policy assessment of 14 December 2023.

²       P Amatyakul, F De Fiore, M J Lombardi, B Mojon and D Rees, "The contribution of monetary policy to disinflation", BIS Bulletin, no 82, 20 December 2023.

³       B Doornik, D Igan and E Kharroubi, "Labour markets: what explains the resilience?", BIS Quarterly Review, 4 December 2023.

⁴       A Carstens, "A story of tailwinds and headwinds: aggregate supply and macroeconomic stabilisation", speech at the Jackson Hole Economic Symposium, 26 August 2022.

⁵       Bank for International Settlements, "Monetary and fiscal policy: safeguarding stability and trust", Annual Economic Report, June 2023, Chapter II.