The COVID-19 pandemic continues to challenge central banks. When the pandemic struck and economies nosedived, the pressure was on central banks to rescue and sustain the economy. This led to a quick opening of liquidity floodgates to keep the economy humming. A year later fortunes have changed. And now a rise in inflation has put pressure on central banks to tighten the hosepipes they opened last year. How do central banks cope with this sudden change of events?
The accompanying graph pictures this turnaround of fortunes in a few selected advanced economies. We see that since the pandemic in February 2020, inflation in these economies which was already lower than the target of 2 percent, started drifting even lower. The low inflation indicated low demand which was because of global a slowdown as policymakers imposed lockdowns that curtailed economic activity.
From Jan 2021 onwards, we see rise in inflation because of stronger recoveries in economies and partly because of the base effect. In its June 2020 outlook, the International Monetary Fund had projected the world economy and advanced economies to shrink 4.9 percent and 8 percent respectively in 2020. Since then, IMF has upgraded its forecast in subsequent outlooks. In the recent July 2021 outlook, it said the world economy and advanced economies contracted 3.2 percent and 4.6 percent in 2020.