Laying a robust macro-financial foundation for the future

Speech by Mr Agustín Carstens, General Manager of the BIS, on the occasion of the Bank's Annual General Meeting, Basel, 30 June 2024.

Welcome to the presentation of the 94th BIS Annual Economic Report.

The global economy seems poised for a smooth landing. As inflation continues its descent towards central bank targets, activity remains resilient. At the same time, the financial system appears to have adjusted smoothly to higher interest rates.

These outcomes were not guaranteed when we met last June. At that time, inflation had started to decline. But this seemed to be an easy gain; further progress looked more difficult. Meanwhile, bank failures on both sides of the Atlantic raised concerns that financial systems might be too brittle to withstand the policy measures needed to safeguard price stability. 

We should recognise central banks' success. They faced the largest and most sustained rise in global inflation since the 1970s. They took forceful action.

And it worked.

Inflation declined with little collateral damage to growth, employment or financial stability. In no small measure, this was possible because central banks could draw on their hard-earned credibility and prevent a high-inflation mindset from creeping in. This greatly lowered the costs of disinflation.

While welcoming these positive developments, we should not be complacent. The job is not yet done. Inflation is far below its peak, but it is not low enough. Key relative prices remain out of step with their pre-pandemic trends. The risk to food and energy prices, and financial markets, from geopolitical tensions is ever-present. High-for-long interest rates could still be necessary, testing economic and financial system resiliency. And some risks lie beyond central banks' control. In many jurisdictions, unsustainable fiscal trajectories threaten macro-financial stability. Slow productivity growth could make the economic and political environment even more challenging.

Before I address the policy implications that follow from these challenges, let me first review in detail the key developments of the past year.

Growth proved more resilient than expected for several reasons.

First, labour markets were unusually buoyant. Given GDP outcomes, we would have expected unemployment rates to rise much more. The exceptional degree of labour market tightness was partly due to pandemic-induced behavioural shifts, not least the outsized rebound in the labour-intensive services sector.

Second, the transmission of monetary policy to the real economy proceeded smoothly. One reason was its measured impact on financial conditions. Overall, the financial system digested the interest rate hikes well – after the stresses in March 2023, any signs of strain remained localised and modest. While banks were cautious in granting credit, buoyant market sentiment kept risk spreads compressed.

At the same time, tighter financial conditions passed through smoothly into real activity. Fixed rate loans and longer loan maturities delayed the impact of higher rates on borrowers. Large cash cushions prevented sharp cutbacks in business investment. And savings accumulated during the pandemic continued to bolster household consumption.

However, the extent of economic resilience varied across countries. The US economy has displayed remarkable strength, in part supported by fiscal spending. In stark contrast to previous global monetary tightening episodes, emerging market economies generally outperformed, helped by stronger policy frameworks and robust domestic financial systems.

Elsewhere, growth was generally weaker. Many European economies still reeled from higher energy prices. Subdued global trade weighed on Asian economies that rely more heavily on manufacturing exports.

Inflation continued to retreat from its peak. Slower growth in core goods prices explains much of the decline, driven by benign supply chain conditions and a continued spending rotation towards services. Instead, services price growth took over as the main inflation driver. Concerningly, price growth in these items tends to persist. Thus, inflation remains above central bank targets across much of the world, although it is much more subdued in parts of East Asia, particularly in China.

Monetary policy deserves much of the credit for lowering inflation. Higher interest rates curtailed demand. It is no coincidence that price growth fell most in sectors where prices are more sensitive to excess demand.

Given that policy tightening was broad-based across countries, it helped to restrain demand at a global scale, and hence to lower commodity prices.

Perhaps most crucially, forceful tightening reinforced central banks' credibility and pre-empted a shift to a high-inflation regime. Inflation expectations tell the story. Near-term inflation expectations fell back, retracing their upward drift during the inflation flare-up. Medium-term inflation expectations hardly budged, even as actual inflation approached double-digit levels.

More recently, monetary policy settings have begun to diverge. Some central banks have started to lower rates. Others have held steady. This is to be expected. The common supply and commodity price shocks that led almost all central banks to tighten policy have started to fade. This leaves country-specific idiosyncratic price movements as the main inflation driver. But even if central banks focus on domestic conditions, their decisions can still have global ramifications, particularly for exchange rate movements and capital flows.

Now, despite the notable progress made so far, it is too soon to declare victory. Several important pressure points remain, which could derail the smooth landing. These include persistent inflationary forces, macro-financial vulnerabilities, fiscal trajectories and low productivity growth.

Two relative prices are key for the inflation outlook. The pandemic disrupted the paths of both. One is the price of services relative to that of core goods, which remains well below its pre-pandemic trend. The other is the price of labour relative to that of goods and services – that is, real wages – which also lost ground during the unexpected inflation surge. An overly rapid reversion of either – or both – of these relative prices could create material inflationary pressures. It won't derail disinflation – central banks will make sure of that. But it would mean fewer and more gradual rate cuts or even, in the extreme, rate increases.

This, in turn, could have adverse macro-financial implications. With high debt and depleted savings cushions, household and firm balance sheets could buckle under the cumulative effect of monetary policy tightening. The commercial real estate sector faces structural and cyclical headwinds that could expose vulnerabilities in the broader financial system. The non-bank financial institution (NBFI) sector, notably private credit, is particularly susceptible to higher interest rates after expanding rapidly when rates were low. Added to this, stretched asset price valuations and the turning credit cycle could amplify any emerging financial stresses. We are still in the very early stages of this process. It typically takes more than a year from the turning of the financial cycle for loan problems to emerge, with repercussions for economic activity.

Fiscal outlooks are even more concerning. In the near and medium term, they pose the biggest threat to macroeconomic and financial stability. Fiscal support continues to affect demand and inflation dynamics in many countries. There is a risk that overly expansionary fiscal policy could add further fuel to inflationary pressures, undoing the hard-earned progress.

Without consolidation, public debt ratios are set to climb, even if interest rates remain below economic growth rates. With mounting spending needs, markets could at some point question fiscal sustainability. High public debt issuance could raise the risk of bond market dysfunction, threatening financial stability.

The resolution of supply chain disruptions and the recovery of labour supply have contributed significantly to the recent disinflation. This serves as a timely reminder of the importance of the supply side for inflationary dynamics.

But unwinding pandemic-related dislocations is a one-time gain.

Productivity growth is the key to strong, sustained supply side performance. After an extended period of low productivity growth in the lead-up to the Covid-19 pandemic, recent technological advances, including in artificial intelligence (AI), raise the prospect of a revival of high productivity growth in the years ahead. But there are no guarantees. Looking beyond AI, high productivity growth will occur only if the right institutional frameworks and policy measures are put in place. We urgently need to identify today's structural headwinds to productivity and address them head on.

In this regard, the increasing turn to protectionist measures in many jurisdictions is cause for great concern. Protectionism makes economies less dynamic, less innovative and less competitive. It makes them more inflation-prone in the short run, since they cannot tap into nimble overseas supply chains to cushion shifts in domestic aggregate demand. And it makes them poorer in the long run.

The question is then, what should policymakers do in this complex and challenging environment?

There is no doubt that the priority for monetary policy is to sustainably re-establish price stability. This requires holding firm in the last mile of disinflation. It means being alert to setbacks and standing ready to tighten once more if needed. It also means safeguarding the room for policy manoeuvre regained after a decade of low-for-long rates. Central banks should not rush to conclude that interest rates must return to pre-pandemic levels, given the uncertainty surrounding the level of neutral rates.

Monetary policy divergence, due to differences in inflation outlooks, could create short-term challenges related to capital flows and exchange rates. Thankfully, emerging markets are better equipped to deal with such challenges than in the past. Strong policy frameworks, underpinned by central bank independence, a broad set of policy tools, and ample foreign exchange reserve buffers provide robust lines of defence. Foreign exchange intervention can play a useful complementary role if used judiciously and not as a substitute for necessary macroeconomic adjustments.

Prudential policy must further strengthen the resilience of the financial system in preparation for credit losses ahead. Macroprudential policy must resist the temptation to ease prematurely. For microprudential policy, tight supervisory scrutiny remains essential to minimise the likelihood of near-term stress. And it is essential for full implementation of Basel III to proceed without delay.

As already mentioned, fiscal policy must consolidate. In the near term, this would help relieve inflationary pressure. It would also lower the risk of bond market disruptions and resulting financial stability repercussions. From the perspective of longer-term fiscal sustainability, the need to consolidate has never been greater. The end of low-for-long interest rates intensifies the urgency to put the fiscal house in order, and multi-pronged consolidation strategies should be considered.

While sound macroeconomic and prudential policies are foundational for an economy to realise its potential, structural policies are the key to lift living standards sustainably. A more resolute mindset and determination are now needed to reinvigorate the supply side of the economy.

But let me return to central bank matters. Taking a step back, we see that the pandemic and surge in inflation were part of a series of extraordinary events that have shaped monetary policy since the turn of the century. The economic outcomes and the conduct of monetary policy over this period point to several lessons for the future. Claudio will elaborate on this in his presentation, so let me just highlight a few of the key lessons.

To start with, monetary policy is a powerful tool. Recent events have confirmed once more that decisive monetary tightening can pre-empt a transition to a high-inflation regime. We have also seen how forceful action by central banks during stress episodes can stabilise the financial system and prevent disinflationary spirals. And the experience of emerging market economies has shown how the use of FX intervention and macroprudential measures can improve policy trade-offs.

But recent decades have also revealed monetary policy's limits. Exceptionally strong and prolonged monetary easing has diminishing returns. It cannot fine-tune inflation in a low-inflation regime, and it can generate unwelcome and persistent side effects. Meanwhile, the proliferation of monetary policy instruments, as well as unrealistic expectations about what they can deliver, has complicated communication.

These lessons highlight the importance of five features that could inform refinements to frameworks: robustness, realism in ambition, safety margins, nimbleness and coherence across policy domains. Together, they can reduce the risk that monetary policy, just like fiscal policy, is relied upon excessively to drive growth.

A different challenge for central banks stems from the rise of AI. As Hyun will explain later, the capabilities of the new generation of AI models will have a profound impact on the economy and financial markets. AI has implications for productivity, aggregate demand and financial stability. It could also transform the job of central banks, as the same tools that are being adopted by individuals and businesses are well-suited for monitoring the economy and financial system. Central banks need to stay ahead of developments to harness the full potential of AI. Data availability and data governance are key in this endeavour. Both will require investment in technology and in human capital. Above all, the challenges in the age of AI require close cooperation among central banks.

Let me conclude. It is no small feat that the economy seems poised for a smooth landing. It is reassuring that forceful, decisive policy actions by central banks have proven their effectiveness against a unique combination of powerful forces threatening price stability. 

Policymakers must finish the job of reestablishing price stability and lay the foundation for durable accelerated economic growth. The presence of risks, including persistent inflationary forces, macro-financial vulnerabilities and real-side headwinds, requires vigilance and readiness for action.

Lessons from the turbulent period since before the Great Financial Crisis point to the power, but also the limits, of monetary policy. It is an effective tool to deliver low inflation and stabilise the financial system in times of crisis.

But it is not capable of steering already-low inflation to hit precise numerical targets. And it should not be relied upon as an engine of economic growth.

Looking ahead, central banks will need to grapple with the rise of AI – both in reacting to its effects on the economy and in using the new technology to fulfil their mandates. To do this, central banks need to come together to foster a "community of practice" to share knowledge, data, best practice and tools.

But let me also stress that laying the foundation for a brighter economic future will require actions from others as well, most notably fiscal authorities.

It is my conviction that as we tackle all the items on this agenda, we will be laying solid foundations for faster, more equitable and sustained economic growth.