In the Bollywood movie Jab We Met, the key character Geet (played by Kareena Kapoor) pleads to god to end the chaos as enough drama had already happened. She wants things boring again. I will not be surprised if central banks worldwide are making similar requests to Santa even without watching the movie.
Central banks have barely been in peace since the 2008 crisis, moving from one maze to another. Before the 2008 crisis, the world of central banking was mostly boring. The world economy benefited from a rare combination of low inflation and high growth. Economists had named this phase as great moderation. Robert Lucas, the Nobel Prize-winning economist, had even remarked that the “central problem of depression-prevention has been solved, for all practical purposes, and has in fact been solved for many decades”.
The 2008 crisis turned all these impressions upside down. After bouts of financial instability and failures of financial institutions, developed economies suffered from a problem of low inflation and low growth. Central banks were forced into keeping interest rates low and also increasing balance sheets to provide constant liquidity to the markets. Developing economies had much better macroeconomic outcomes, but still, the pre-crisis peaks were beyond reach. The slowdown in the developed world also weighed on the overall world economy.
Just as things were beginning to improve, the world was hit by a severe pandemic. The last time humanity saw such a pandemic was 100 years ago, which made it really difficult to react and act. The world collectively imposed a lockdown to prevent the spread of the disease. The health crisis quickly turned into a serious economic crisis, as economic activity contracted like never before. Central banks across the world not just cut interest rates sharply but also infused a high amount of liquidity in the markets.
Just as the pandemic was easing, Russia declared war on Ukraine. Both countries were exporters of key commodities such as oil, gas and food grains. As the supply from these two countries declined, the prices rose sharply. Inflation, which was mostly absent since the 2008 crisis, suddenly became a major problem. With economies still recovering from the pandemic, authorities were again caught off guard. As inflation touched 40-year highs in developed countries, central banks rushed to increase interest rates sharply. The Federal Reserve led the fight against inflation, increasing its policy rates by 75 bps in four consecutive meetings. The 40-year high inflation was addressed with a similar monetary policy 40 years earlier under Fed Chair Paul Volcker.
Other central banks followed the Federal Reserve and tightened interest rates significantly. Recent research by the Bank for International Settlements (BIS) economists noted two things about the recent episode of rising interest rates. First, it was the most synchronised tightening episode of the past 50 years. In the 1970s, when inflation rose similarly, 90 percent of central banks in the BIS sample increased policy rates. This time the number is even higher with 95 percent of a sample of 28 central banks raising their policy rates. Second, the pace of rate increases was about twice compared to their historical pace.
Will central banks get peace or get into a new maze in 2023? Early evidence suggests that old problems will continue and new ones get added to them. Here’s why.
First, interest rate increases will not just lead to a slowdown of growth but also raise concerns over financial instability. The 2008 crisis and the pandemic have led to a significant rise in debt levels, both for the government and the private sector. Low interest rates before the world was hit by high inflation were helping these high-debt entities tide through the debt crisis, but that luxury is not available anymore.
Second, higher interest rates led to concerns over currency depreciations of not just emerging economies but also developed countries. Leading currencies such as the euro and the pound depreciated significantly due to the Federal Reserve’s policies. In particular, the depreciation of the pound created tremors in the London markets leading the Bank of England to take measures to prevent the depreciation of the currency. Developed country central banks usually do not intervene in the currency markets but this time it was different.
Third, digitalisation and climate change are new mazes that central banks will have to get through. Central banks are going to be really busy in the space of digitalisation as it continues to spin new models of banking and currency. We will see a few central banks including the Reserve Bank of India (RBI) issue central bank digital currency in 2023. The volatility of private cryptocurrencies will threaten financial stability, as recently suggested by RBI Governor Shaktikanta Das. Climate change has been a burning issue for some time now but it keeps getting sidelined due to multiple economic shocks. Central banks will like to be seen as serious participants in addressing climate change but they have not been able to do so due to economic challenges. Moreover, uncertainty in understanding the impact of climate change on economies makes the task of addressing it with policy measures more difficult.
Overall, the year 2023 will be an interesting one, filled with twists and turns. Santa and the New Year are not going to agree to the requests of central banks to make things boring. Even in the movie Jab We Met, the god did not grant the request made by Geet, the movie saw more excitement later. Central banks should instead take some ideas from another character in the movie - Aditya played by Shahid Kapoor. Aditya learning from the free-spiritedness of Geet decides to take his problems head-on and turns around his business organisation. The central banks will have to do the same in 2023.
Amol Agrawal is faculty at Ahmedabad University. Views are personal and do not represent the stand of this publication.
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