7 November 2023

The Best Way to Fight Inﬂa�on 1
Creon Butler 2 and Yougesh Khatri 3

Do we need to rethink our monetary policy framework either in the light of what we learnt
through the 2021-23 global inﬂation shock, or as a result of major structural changes that
we know to be underway in the global economy?

An earlier dra� of this paper was presented at the Nomura Founda�on Macro Economy Research Conference
on “Monetary Policy and Its Impact During Inﬂa�on” on 19 October 2023
2
Director, Global Economy and Finance Programme, Chatham House
3
Associate Fellow, Global Economy and Finance Programme, Chatham House
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ContentsSec�on 1 Overview
Sec�on 2 The pre-pandemic consensus on the most appropriate monetary policy
framework
Historical perspec�ves on ﬁgh�ng inﬂa�on
The consensus monetary policy framework before the GFC
Country varia�ons in the pre-GFC framework
Unconven�onal monetary policies post GFC
Financial stability frameworks post GFC
Sec�on 3 The global inﬂa�on shock 2021-23
Ways of viewing the causes of the shock- Unexpectedly strong demand and constrained supply- Excessive monetary growth- Rapidly closed output gap
The central bank responseSec�on 4 Other factors that should be factored into a review of monetary policy
frameworks
Fragmenta�on in global markets
Extreme shocks
Global investment gap
Poli�cal polarisa�onSec�on 5 Implica�ons for the consensus monetary policy framework and how it is operated

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Sec�on 1: Overview
The global inﬂa�on shock of 2021-23 has once more focussed economic policy makers
around the world on the challenge of controlling inﬂa�on.
According to the latest IMF World Economic Outlook 4 global headline inﬂa�on peaked at
11.6% in the second quarter of 2022 (at a quarterly annualised rate) compared with anannual average rate of 3.5% in 2019-17. It has subsequently declined to 5.3% (as of Q22023). However, the experience has raised two dis�nct, but related ques�ons.
First, are there lessons we need to learn on how to ﬁght inﬂa�on from the experience of theshock itself? And second, are there other trends underway in the global economy andpoli�cs that should lead us to update the current monetary and ﬁnancial stability
framework?
The two decades up to the 2008-9 Global Financial Crisis (GFC) saw the emergence of abroad consensus in advanced - and many emerging - economies on the most eﬀec�ve way
to control inﬂa�on and maintain ﬁnancial stability.
Key elements included: independence (or opera�onal autonomy) of monetary and ﬁnancial
regulatory authori�es; use of an inﬂa�on targe�ng policy framework with a symmetrictarget range around 2%; emphasis on transparent frameworks and eﬀec�ve communica�on;
and the use of short-term interest rate as the sole policy instrument.
This was supplemented a�er the GFC with (a) the use of Unconven�onal Monetary Policy(UMP) such as Quan�ta�ve Easing (QE) in circumstances where the zero lower bound (ZLB)
for interest rates had eﬀec�vely been reached; and (b) the development of new policy
frameworks and instruments to ensure macro-ﬁnancial stability along-side the opera�on ofmonetary policy.
However, this framework has been severely tested during the past three years. Central
banks had to cope ﬁrst with the complex and fast changing impacts of the pandemic
followed by the global energy, fer�liser and food shortages that followed Russia’s atack on
Ukraine. This created a very diﬃcult policy making environment.
But some commentators also argue that central banks compounded the inﬂa�on problem
through signiﬁcant and consequen�al errors in how they ran monetary policy - both in the
period from the GFC to the pandemic, and then during the pandemic itself. Morespeciﬁcally, a�er each shock, they kept monetary policy too loose for too long.
To the extent this was true, it raises the ques�on of whether the errors arose because of
ﬂaws in the consensus framework itself, or how it was operated. For example, did central
Interna�onal Monetary Fund (2023), World Economic Outlook October 2023: Navigating Global Divergences,
Interna�onal Monetary Fund, htps://www.imf.org/en/Publica�ons/WEO/Issues/2023/10/10/world-economicoutlook-october-2023

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banks misdiagnose how the pandemic - combined with government lock downs andﬁnancial support for those aﬀected - would aﬀect the balance of supply and demand?
In any event, to correct the mul�-decade high inﬂa�on that emerged by 2022, central banks
were forced to raise interest rates very rapidly from early 2022 onwards.
Ideally the adjustment in interest rates would have been more gradual, but once theinﬂa�on surge was underway this was no longer an op�on.
In some countries the speed of the interest rate increase led to stress in the ﬁnancial system,
either because lax pruden�al regula�on had allowed certain banks to become too exposed
to interest rate vola�lity or because tougher market condi�ons exposed long-standing
management weaknesses.
It has also had distribu�onal eﬀects in so far as the poor are generally less able to protect
themselves than the rich from surging inﬂa�on due to inelas�c demand for basic
consump�on goods, lack of credit facili�es and propor�onately greater reliance on
conven�onal energy supplies. 5
A further ques�on, therefore, is whether there is more that should be done, alongside
reviewing the monetary policy framework itself, to mi�gate the impacts of very sharp
interest rate rises on the economy. This could include strengthening exis�ng pruden�al andmacro-pruden�al instruments and/or expanding their scope and beter monetary and ﬁscal
policy coordina�on.
Lastly, as we consider the lessons to be learnt for the interest rate se�ng framework fromthe recent inﬂa�on shock, we should also take the opportunity to ask whether there areother structural changes underway in our economies and poli�cs which may require changes
in the established framework for ﬁgh�ng inﬂa�on.
In this paper we focus on four such factors: the trend towards fragmenta�on in global
markets for goods, services, labour and capital; the appearance of much bigger and more
frequent economic shocks reﬂec�ng geopoli�cal, climate-related, global health and otherdevelopments; the impact of enormous new spending needs for the net zero transi�on;and the trend towards greater poli�cal polarisa�on which could threaten public consent formonetary policy independence.
This is not an exclusive list of trends (which might include ﬁntech and digital currencies,
public and private sector debt overhangs) that could yet prove large enough to impact on
the opera�on of monetary policy and its ins�tu�ons, but we argue they are currently themost signiﬁcant and also most in need of pre-emp�ve ac�on by central banks.
Analysis of these factors could reenforce the lessons for monetary policy to be learnt fromthe recent inﬂa�on shock or it may suggest other measures that it would be prudent to take.
Pabst, A., and Mosely M. (2022), ‘The Unequal Impact of Rising Inﬂa�on’, Na�onal Ins�tute of Economic andSocial Research Blog, 31 January 2022, htps://www.imf.org/en/Publica�ons/WEO/Issues/2023/10/10/worldeconomic-outlook-october-2023

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Our focus in this paper is primarily on the advanced economies (US, euro area, Japan andUK), although we also highlight lessons that we think are of wider applicability in e.g.,
emerging economies. This is important as in the course of the pandemic several emerging
economies adopted new post-GFC techniques, such as quan�ta�ve easing, which had un�lthen only been seen in the advanced economies.
This rest of this paper is structured as follows. Sec�on 2 describes the key elements (andtheir origins) of the broad consensus on how to control inﬂa�on and maintain macroﬁnancial stability that prevailed in advanced economies and many emerging economies in
2019. Sec�on 3 sets out diﬀerent ways of viewing the causes of the 2021-23 global inﬂa�on
shock. It then considers the cri�que now made by some commentators of central bankac�ons during the crisis and what this might mean for the consensus monetary policy
framework. Sec�on 4 describes in more detail the four trends that appear likely to haveimportant implica�ons for the opera�on of monetary policy in the years ahead and which it
would be advisable for central banks to an�cipate. Sec�on 5 concludes by proposing
prac�cal policy measures, based on the previous analysis, which could enhance both thecore monetary policy framework and complementary policies.

57 November 2023

Sec�on 2. The pre-pandemic consensus on the most appropriatemonetary policy framework
This sec�on sets out brieﬂy the key elements and origins of the consensus on how to control
inﬂa�on and maintain ﬁnancial stability, as established in the decades before the GFC, andhow that has evolved in the a�ermath of the GFC. It also highlights some of the diﬀerencesin how the model was implemented between the major western economies. The aim here –in the space available - is to draw out the stylised facts rather than provide a rigorous
academic review.
The links between inﬂa�on, monetary policy and ﬁnancial stability have been clear in the
post-Breton Woods exchange rate era. Figure 1 highlights how forceful policy rateincreases, in the context of inﬂa�on pressures, have o�en been followed by ﬁnancial sector
stresses or crises.
Figure 1. US Federal Funds Rate, CPI Inﬂa�on and Financial Stability

Source: FRED database, NBER

Monetary policy has prevailed as the dominant counter-cyclical policy used to pursue pricestability and a broad consensus has emerged on the key elements of an eﬀec�ve monetary
policy framework. This has however been achieved through a combina�on of painful policy
and conceptual mistakes, crises and concerted research eﬀorts. Financial stability
frameworks have also converged in the major advanced economies, although there remains
some diversity in views on the role of monetary policy in pursuing ﬁnancial stability.

Historical perspec�ves on ﬁgh�ng inﬂa�on
The “Great Inﬂa�on” (mid-1960s through early 1980s) period in the US “brought atransforma�ve change in macroeconomic theory and, ul�mately, the rules that today guide67 November 2023
the monetary policies of the Federal Reserve and other central banks around the world”. 6
The background to the Great Inﬂa�on period was the post-War dominance of (Keynesian)ﬁscal policy, large deﬁcits (“Great Society” spending and the Vietnam War) and elevatedgrowth of the money supply (above real GDP)7 which were already contribu�ng to inﬂa�on
exceeding 6 percent in early 1970. The Nixon administra�on con�nued deﬁcit spending,appointed presiden�al councillor Arthur Burns as Fed chair and suspended the dollar’s linkwith gold in 1971 (eﬀec�vely ending the Breton Woods system of exchange rates and taking
the world into the ﬁat money era).
The ﬁrst oil price shock hit in 1973, contribu�ng to inﬂa�on in the US peaking at over 12
percent in late 1974. Even when base eﬀects fell out, headline inﬂa�on remained above 5
percent as inﬂa�on expecta�ons became entrenched and money growth remained high. The
second oil price shock contributed to headline inﬂa�on peaking at over 14.5 percent in
1980.
Enter Paul Volker, the “pragma�c monetarist” 8, who took the helm of the Fed in 1979 andproceeded with aggressive hiking of policy rates, which were associated with recessions andthen substan�al declines in inﬂa�on. These policy ac�ons (while deeply unpopular at the�me in many quarters) credibly brought down inﬂa�on and inﬂa�on expecta�ons.
Bernanke 9 noted that Volker “came to represent independence…He personiﬁed the idea of
doing something poli�cally unpopular but economically necessary.” The importance ofcredibility, inﬂa�on expecta�ons and a central bank insula�on from poli�cal pressures tokeep rates low or mone�se deﬁcits were par�cularly highlighted by this experience. 10
Following Volker, monetary policy began to be more consensual and Issing (2010) 11 suggests
three reasons:1) A convic�on emerged to avoid the painful mistakes of that period;2) Research was spurred by this experience to carefully study the ques�on of op�malmonetary policy; and,
3) Given the Bundesbank’s rela�ve success with inﬂa�on over that period, its model
was increasingly seen as a diﬀerent and successful op�on.

Bryan, M., “The Great Inﬂa�on: 1965-1982”, Federal Reserve History, 22 November 2013,
htps://www.federalreservehistory.org/essays/great-inﬂa�on.
7
Ibid.
8
Meltzer, A. H. (2009), A History of the Federal Reserve, Vol. II, book one, Chicago
9
New York Times, 9 December 2019.
10
One of the ﬁrst policies of the UK Chancellor of the Exchequer Gordon Brown (a�er labour won the elec�onin 1997) was to make the Bank of England independent and this quote from his announcement speech nicely
summarises the general ra�onale: “The previous arrangements for monetary policy were too short-termist,
encouraging short but unsustainable booms and higher inﬂa�on, followed inevitably by recession. This is why
we promised in our elec�on manifesto to ... reform the Bank of England to ensure that decision-making onmonetary policy is more eﬀec�ve, open, accountable and free from short-term poli�cal manipula�on.”
11
Issing, O. (2010), “The Development of Monetary Policy in the 20th Century – Some Reﬂec�ons”, Policy
Colloquium at the Na�onal Bank of Belgium Brussels, 29 April 2010.
6

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Two (eventual Nobel-Prize-winning) theore�cal contribu�ons during the Great Inﬂa�on
period were central to underpin the eﬀec�veness of monetary policy.
•

Work on ra�onal expecta�ons highlighted how interac�ons between policy makers
and private agents - and their expecta�ons forma�on - are central to the forma�onof op�mal monetary policy. 12•

The theory of �me-inconsistency of policy 13 suggested an inherent bias towards
inﬂa�on given the constant tempta�on for policy makers to boost output throughsurprise expansions of the money supply.

To address the inﬂa�on bias problem, Barrow and Gordon (1983)14 proposed removing
monetary policy discre�on to ensure a �me-consistent adherence to the price-stability
objec�ve. This did not resonate with central bankers as a viable op�on given their reality offacing complex and unpredictable circumstances. Yet thinking about monetary policy rules
did have some very construc�ve consequences, including the approach of addressing �meinconsistency through credibility and communica�ons and the insights of the Taylor rule 15.
Rogoﬀ (1985) 16 also demonstrated how the inﬂa�on-bias from the �me-inconsistency
problem could be reduced in the context of an independent and conserva�ve (with a corefocus on stabilizing inﬂa�on) central bank.
The Great Inﬂa�on was largely a global phenomenon with a notable excep�on of Germany(see Figure 2). The Bundesbank “model” worked well during that �me which focused
aten�on on how it diﬀered from monetary policy in other major economies. Germany’s
experience of hyperinﬂa�on and loss of two currencies (1923 and 1948) strongly shaped thepreferences of people in support of conserva�ve monetary policy focused squarely on pricestability. 17 Independence of the Bundesbank from poli�cal interference was embedded in(what became) the Law Concerning the Deutsche Bundesbank (1957). This mandated“safeguarding the currency”, which was soon interpreted as maintaining price stability. 18 The
Bundesbank adopted a monetary targe�ng (rule-oriented) approach post Breton Woods
which seemed to save Germany from the Great Inﬂa�on but also contributed to theDeutsche Mark being one of the most stable of the major currencies un�l the adop�on of
the Euro. Thus, the German central bank model was also important in shaping bothmonetary research and prac�ce. The public acceptance of a very hard form of independence
Lucas (1972), “Expecta�ons and the Neutrality of Money”, Journal of Economic Theory, 4, 103-124. There is
now a vast literature on the role of expecta�ons in monetary policy. While much of the literature on op�malmonetary policy adopts New Keynesian models and emphasises ra�onal expecta�on, the assump�on ofra�onal expecta�ons is generally thought to fall far short of reality. See for example, Blanchard, O. (2018), “On
the future of macroeconomic models”, Oxford Review of Economic Policy 34 (1-2), 43-54.
13
Kydland, F. and Prescot, E. (1977), “Rules Rather Than Discre�on: The Inconsistency of Op�mal Plans”,
Journal of Political Economy, pp. 473-491
14
Barro, R. and Gordon, D, “A Posi�ve Theory of Monetary Policy in a Natural Rate Model”, Journal of Political
Economy, Volume 91, Number 4, Aug., 1983
15
Taylor, J (1993): “Discre�on versus policy rules in prac�ce”, Carnegie-Rochester Conference Series on Public
Policy, no 39, pp 195–214.
16
Rogoﬀ, Kenneth. 1985. “The Op�mal Degree of Commitment to an Intermediate Monetary Target.” Quarterly
Journal of Economics 100: 1169-1189.
17
Issing (2010) previously cited.
18
Ibid.
12

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was reﬂected subsequently in the cons�tu�onal arrangements for the ECB, and in theGerman resistance to quan�ta�ve easing in the a�ermath of the GFC.
Figure 2: Headline CPI Inﬂa�on: US, Japan, Germany, UK and World

Source: World Bank Inﬂa�on Database 19

To sum up the implica�ons of the most important theore�cal developments and hard-won
prac�cal experience around the Great Inﬂa�on:•

Anchoring inﬂa�on expecta�ons is the key and that involves establishing credibility(established by a consistent track record) and independence of central banks (bothlegisla�ve and de facto) with a clear price-stability target.

•

The roles of central bank communica�ons and transparency as credibility-building
devices (especially for inﬂa�on targe�ng – see below) have also risen over �me andare now seen as essen�al parts of a credible and successful monetary policy.

Following the vola�lity of the Great Inﬂa�on period (1965-1982) came the Great
Modera�on – typically taken as the period from 1985 up to the 2007 (ahead of the GFC).
During the Great Modera�on, inﬂa�on was on average less than half the level of the Great
Inﬂa�on period and was also much less vola�le (see Table 1).

Ha, J., Kose, M. A., Ohnsorge, F. (2021), "One-Stop Source: A Global Database of Inﬂa�on", Policy ResearchWorking Paper; No. 9737. World Bank, Washington, DC."

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Table 1: Great Inﬂa�on vs Great Modera�on: Average Inﬂa�on and Inﬂa�on Vola�lity
GermanyJapan
UK
Average Inflation
7.3
10.3
0.66
3.21

US

Great Inflation (1965-1982)
Great Moderation (1985-2007)

4.3
1.95

6.5
3.05

Great Inflation (1965-1982)
Great Moderation (1985-2007)

Inflation Volatility (Standard Deviation)
1.78
4.77
5.99
3.36
1.32
1.25
2.00
1.07

The Great Modera�on also was a period of reduced vola�lity of output and extended cycles
in the US and other advanced economies (see Figures 3a and 3b). This improved macro
stability is o�en atributed to the improved counter-cyclical policy frameworks thatprevailed 20, as described above, but could also be due to good luck (less severe shocks forexample) and changes in the structure of advanced economies. 21 Advanced economies saw
a decline in the share of manufacturing (which tends to be more vola�le) and a rise in theshare of services - this would tend to reduce vola�lity. Other structural factors – such astechnology, deregula�on, increased global trade and capital ﬂows, and just-in-�me supply
chains might also contribute to lower vola�lity of output.
Figure 3a: US Growth and Vola�lity: Great Inﬂa�on Period vs Great Modera�on Period

Source: FRED Database and authors’ calcula�ons

Cecche�, S. G., Flores-Lagunes, A.; Krause, S. (2004), Has Monetary Policy Become More Eﬃcient? a Cross
Country Analysis”, NBER Working Paper, 2004.
21
Hakkio, G., “The Great Modera�on”, Federal Reserve History, November 2022.
htps://www.federalreservehistory.org/essays/great-modera�on
20

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Figure 3b: UK Growth and Vola�lity: Great Inﬂa�on Period vs Great Modera�on Period

Source: FRED Database and authors’ calcula�ons

The consensus monetary policy framework before the GFC
A variety of monetary policy frameworks (and related nominal anchors) persist across theadvanced, emerging, and low-income countries, spanning exchange rate targe�ng, monetary
aggregate targe�ng, inﬂa�on targe�ng and other eclec�c frameworks. 22
Figure 4: Incidence of Monetary Policy Frameworks Over Time (all countries)

Source: Cobham (2021) (ER=exchange rates; MT=monetary targe�ng; IT=inﬂa�on targe�ng;
UD=unstructured discre�on; LSD=loosely structured discre�on; WSD=well-structured discre�on)

Cobham, D. (2021), “A comprehensive classiﬁca�on of monetary policy frameworks in advanced andemerging economies”, Oxford Economic Papers, 73(1), 2021, 2–26.

22

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The introduc�on of an inﬂa�on targe�ng (IT) monetary framework, pioneered by the
Reserve Bank of New Zealand in 1989, brought many of the prevailing elements of monetary
policy consensus together in a compelling way. IT involves adop�on of an explicit andpublished inﬂa�on target, publica�on of the central bank’s inﬂa�on forecasts, and monetary
policy—within an independent central bank—primarily geared towards ensuring theinﬂa�on forecast moves to the inﬂa�on target over a speciﬁed �meframe. The frameworknecessitates high degrees of transparency and accountability and eﬀec�ve communica�ons;
and has been adopted by an increasingly large number of countries according to a recent
monetary framework classiﬁca�on system 23 (see Figure 4).
The ECB and Fed have adopted many of the elements of IT but do not oﬃcially callthemselves inﬂa�on targeters. Since the adop�on of its new framework in 2020, the Fed’s
framework has been described as moving from ﬂexible inﬂation targeting to ﬂexible
average inﬂation targeting, with the Fed’s long-run objec�ve for inﬂa�on shi�ing to it
seeking “to achieve inﬂa�on that averages 2 percent over �me” 24.
Whether formally or ﬂexibly pursuing an inﬂa�on target, the major advanced economies orregions have converged on opera�onally independent central banks with a focus on an
inﬂa�on target (annual target, range, on average or over the long term) and full
employment as primary objec�ves, using inﬂa�on forecasts (with substan�al transparency
and communica�on around these), using overnight policy interest rates as a primary
instrument, and open market opera�ons (OMOs) and lending/deposit facili�es to keep
overnight market rates around the target policy rate. Unconven�onal monetary policies are
discussed below.
Pre-GFC, the monetary transmission mechanism under tradi�onal monetary policy in anadvanced country involved changes in the policy rate (monetary policy instrument) aﬀec�ng
market rates (and thus cash ﬂows and credit), asset prices (and thus wealth and collateralvalues), expecta�ons/conﬁdence (and thus consump�on and investment) and exchange
rates 25 which push aggregate demand towards aggregate supply (output) and thus guideinﬂa�on towards the target range. The full transmission lags of monetary policy are thought
to be long and variable, and a meta study26 suggests these can exceed 2 years in advanced
economies. There was already much discussion about the ﬂatening of the short-run Phillips
Curve (implying a higher sacriﬁce ra�o) prior to the pandemic.27

Ibid.
2020 Statement on Longer-Run Goals and Monetary Policy Strategy, eﬀec�ve August 27, 2020.
25
Exchange rates aﬀect aggregate demand via the tradable sector but also have a more direct eﬀect oninﬂa�on via the impact on the domes�c price of imported goods.
26
Havraneka, T. and Rusnak, M., (2013), “Transmission Lags of Monetary Policy: A Meta-Analysis”,
International Journal of Central Banking, December 2013.
27“Another key development in recent decades is that price inﬂa�on appears less responsive to resource slack.
That is, the short-run price Phillips curve…appears to have ﬂatened, implying a change in the dynamic
rela�onship between inﬂa�on and employment.” Federal Reserve Vice Chair Richard Clarida, remarks delivered
on Sept. 26, 2019. htps://www.federalreserve.gov/newsevents/speech/clarida20190926a.htm
23
24

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Country varia�ons in the pre-GFC framework
While all four central banks we consider have features of inﬂa�on targe�ng or ﬂexible
inﬂa�on targe�ng there are some important diﬀerences in key aspects such as mandates,deﬁni�ons of targets, opera�ng instruments and opera�ons and communica�on andtransparency frameworks.
Mandates: all 4 central banks target price stability, and the Fed also has another mandate topromote maximum employment (and thus is o�en referred to as having a dual mandate).28
The ECB’s monetary policy framework is perhaps the most complex as it has to consider the
20 member countries.
Deﬁni�ons of Price Stability: The deﬁni�on of price stability also varies between the four
central banks and has changed over �me.
•

In the ECB, the Governing Council had originally deﬁned price stability as “a year-onyear increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of
below 2%” and indicated price stability “is to be maintained over the medium term”.
In 2003, the Governing Council clariﬁed that it aims to maintain inﬂa�on rates below
but close to 2% over the medium term 29, while in the latest (2021) review 30 it has
moved to “aiming for 2% inﬂa�on over the medium term” stressing the target issymmetric (such that nega�ve and posi�ve devia�ons are equally undesirable). The
ECB also plans to consider costs of owner-occupied housing by eventually includingthese in the HICP and in the mean�me, to consider es�mates of these in its wider set
of inﬂa�on indicators.

•

In 2012, the Fed deﬁned explicitly (for the ﬁrst �me) price stability as an inﬂa�on rateof 2 percent. Following the 2019-2020 review of monetary policy, the 2020
Statement of Longer-Run Goals and Monetary Policy Strategy indicated “theCommitee seeks to achieve inﬂa�on that averages 2 percent over �me, andtherefore judges that, following periods when inﬂa�on has been running persistently
below 2 percent, appropriate monetary policy will likely aim to achieve inﬂa�on
moderately above 2 percent for some �me.” 31 (This is the ﬂexible average inﬂation
targeting men�oned earlier). The Fed considers, as its measure of inﬂa�on, theannual change in the price index for personal consump�on expenditures (PCE) rather
the CPI.

In prac�ce, all central banks will consider economic condi�ons in se�ng monetary policy within the ﬂexibility
they have on the speed of returning to the price stability goal.
29
See ECB: htps://www.ecb.europa.eu/ecb/educa�onal/shared/img/MP_0806_300dpi-textsheet.en.pdf
30
See ECB’s monetary policy strategy statement:
htps://www.ecb.europa.eu/home/search/review/html/ecb.strategyreview_monpol_strategy_statement.en.ht
ml
31
See Fed: htps://www.federalreserve.gov/monetarypolicy/review-of-monetary-policy-strategy-tools-andcommunica�ons-statement-on-longer-run-goals-monetary-policy-strategy.htm
28

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In 2013, Bank of Japan (BOJ) deﬁned price stability explicitly for the ﬁrst �me as 2
percent in terms of the year-on-year change in the CPI.

•

In the UK, the Government sets the inﬂa�on target for the Bank of England (BOE) at
2%. If the BOE misses this target by more than 1 percentage point on either side, theGovernor of the BOE must explain why in a leter from the Governor to the
Chancellor of the Exchequer.

Unconven�onal monetary policies post GFC
During the GFC, all four major economies/regions faced the Zero Lower Bound (ZLB) – see
Figure 5 - yet greater monetary accommoda�on was clearly desirable (e.g., Taylor rules
suggested the need for substan�ally nega�ve rates during GFC and especially so during the
COVID shock – Figure 6).
Unconven�onal monetary policies (UMP) were adopted around the GFC and aimed torestore the func�oning of ﬁnancial markets and intermedia�on; and provide further
monetary accommoda�on at the zero lower bound. At the short end of the rates spectrum,some central banks adopted nega�ve rates on banks’ reserves at the central bank (e.g.,
Danish, Swiss, and European Central banks in 2015 and BOJ in 2016). While zero turned out
not to be the lower bound, there was an Eﬀec�ve Lower Bound (ELB) in prac�ce to hownega�ve policy rates could get. Concerns about the eﬀects of nega�ve rates meant the Fed
and BOE chose not to use nega�ve rates, which stands out as one key diﬀerence between
the ECB’s and BOJ’s UMP toolkit versus that of the Fed and BOE.
Figure 5: Policy Rates in the Euro Area, Japan, UK and US

Source: BIS policy rate sta�s�cs

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Figure 6: Taylor Rules for the Fed Funds Rate

Source: Atlanta Fed: htps://www.atlantafed.org/cqer/research/taylor-rule#Tab1

Expansionary monetary (at the zero-lower bound) could s�ll reduce real interest rates(nominal rates minus expected inﬂa�on) if inﬂa�on expecta�ons can be boosted bymonetary policy. Hence central banks moved on to target real long-term yields 32 through:a) Forward guidance – a commitment to maintain low rates for a period of �me or un�la condi�on is met. Forward guidance (if credible) can push down longer rates (andﬂaten the yield curve) and thus provide further accommoda�on.
b) Large scale asset purchases commonly called Quan�ta�ve Easing or QE which could
work through a number of channels including signalling (monetary policy op�ons
beyond the ELB), por�olio rebalancing and exchange rate eﬀects. Quan�ta�ve Easing(QE) added “por�olio rebalancing” to the transmission channel—where central bankbond purchases would push investors along the risk spectrum—which, together withliquidity and policy signalling, worked to push up risk asset prices and weaken
exchange rates and thus support aggregate demand.

32 Making explicit the deﬁni�on of price stability by the Fed in 2012 and the BOJ in 2013 (as discussed above)were used to help anchor expecta�ons (which were deﬂa�onary at the �me).

15

7 November 2023
Figure 7: Balance Sheets of the Fed, ECB and BOJ (index=100 in Jan 2003)

Source: FRED Database

QE was already in use by BOJ since March 2001 in the context of their balance sheetrecession and monetary policy already at the ZLB. This QE was in a rela�vely modest scalecompared to their Quan�ta�ve and Qualita�ve Easing or QQE from 2013. The quan�ta�ve
aspect referred to the purchase of Japanese government bonds (JGBs) and the qualita�veelement referred to purchases by BOJ of risk assets such as ETFs and J-REITs to inﬂuence
premia on risk assets (as well as bond yields). Since 2013, BOJ’s balance sheet has expanded
drama�cally (Figure 7), and it adopted a policy of yield curve control (YCC) in 2016 to target
0% yields on 10-year JGBs (while the target short-term rate was -0.1 percent). 33
In the US and UK, centrals banks adopted QE a�er hi�ng the ZLB.
c) US QE is o�en categorised into three separate stages purchasing US Treasuries andmortgage-backed securi�es, star�ng in November 2008 and tapering of purchases
were announced in June (star�ng in September) 2013 (see Figure 7).
d) The BOE began its QE programme in March 2009, but employing certain constraints(such as not buying more than 70% of any issue of government debt and only
tradi�onal government debt with more than 3-year maturity).
The ECB engaged in large-scale purchases of covered bonds from May 2009 but resistance to
QE from important members of the EA meant that the ECB would not “admit” to QE un�lmuch later. In January 2015, the ECB President (Draghi) announced an expanded asset
purchase programme (a drama�c and long-awaited change in policy to more forceful andeﬀec�ve use of the ECB balance sheet to ease monetary condi�ons).

Despite the drama�c rise in policy rates in other major countries, BOJ’s policy rate remains unchanged (atthe �me of wri�ng in October 2023) at -0.1% and the YCC was eased in July to allow 10-year JGBs to reach 1%.

33

16

7 November 2023
With inﬂa�on in the post-COVID period reaching mul�-decade highs, the major central
banks – with the excep�on of BOJ - have moved to quan�ta�ve �ghtening (QT) and have
hiked policy rates drama�cally star�ng in December 2021 with BOE (see Figures 7 and 5
respec�vely). Inﬂa�on and monetary policy in the post-COVID period is discussed in Sec�on3.

Financial stability frameworks post-GFC
Financial stability frameworks (FSFs), including the choice and implementa�on of policy
instruments, have converged less clearly than monetary policy frameworks in the major
economies. Financial stability mandates (FSMs) also seemed to have played a secondary role
within major central banks pre GFC. 34 Indeed, during the pre-GFC period, ﬁnancial stability,
and monetary policy – during “normal” �mes – were o�en seen as separable, with ﬁnancial
regula�on and supervision being done outside of (or moved out of) central banks. Undercondi�ons of ﬁnancial stresses or crises, central banks have typically provided liquidity andother support, and eased monetary condi�ons to temper the impact of a ﬁnancial crisis on
the real economy. Yet the scale of the GFC required unprecedented policies by central
banks 35 and governments and pointed to large scale and systema�c failures of na�onal (andinterna�onal) frameworks for ﬁnancial stability.
Key research ques�ons on FSFs/FSMs include:-

Should the primary ﬁnancial stability mandate be within the central bank or in a
separate agency (such as a consolidated ﬁnancial supervisory agency)?

-

What should be the primary instruments of a FSF (e.g., macropruden�al,micropruden�al, exchange rate interven�on, and capital ﬂow management tools)?

-

What weaknesses/issues within the pre-GFC FSFs/FSMs in major economies
contributed to the GFC outcome? Are the post-GFC FSFs ﬁt for purpose?

-

How should we deﬁne ﬁnancial stability and what are the trade-oﬀs between
ﬁnancial stability, price stability and employment?

-

What is the role of monetary policy in the context of ﬁnancial stability – shouldmonetary policy “lean” against the forma�on of asset bubbles or should it help
“clean” in the post-bubble a�ermath.

-Should the central bank consider monetary and ﬁnancial stability in a more
integrated framework and if so, how?

Toniolo, G. and White E.N., (2014), “The Evolu�on Of The Financial Stability Mandate: From Its Origins To The
Present Day”, Working Paper 20844, htp://www.nber.org/papers/w20844
35
ECB President Mario Draghi was seen by many as turning around the euro crisis with the “whatever it takes”
commitment (to Europe and the euro area) in the context of the debt crisis.
34

17

7 November 2023
Below we provide a brief review of the key elements of FSFs adopted post-GFC and some of
the important ways monetary policy and FSFs interact (including how monetary andmacropruden�al policies have been, or should be, used together).
During the Great Modera�on, a focus of monetary policy on price stability (together withother structural factors) reduced inﬂa�on levels/vola�lity but perhaps at the price of neglectof ﬁnancial stability. In the a�ermath of the GFC, the importance of FSFs was clear andresulted in major changes in approaches, instruments and ins�tu�ons. Development ofmacropruden�al (focused on the ﬁnancial system) in addi�on to micro-pruden�al (focusedon soundness of individual ins�tu�ons) policies was given considerable aten�on.
One feature of the post-GFC landscape was greater collabora�on through interna�onal
agencies including via the establishment (by the G20) of the Financial Stability Board (FSB) in2009 to “promote interna�onal ﬁnancial stability…by coordina�ng na�onal ﬁnancial
authori�es and interna�onal standard-se�ng bodies as they work toward developing strong
regula�on, supervision and other ﬁnancial sector policies”. 36 Enhanced standards were also
developed by interna�onal standard seters including the Basel III capital adequacy
framework. Monitoring was enhanced through the FSB, BCBS, and IMF (surveillance and
FSAPs). Atempts to address too-big-to-fail included implementa�on of Total Loss-Absorbing
Capacity (TLAC) and more intensive supervision of globally systemically important banks(GSIBs).
Responses in the major economies had some common features:a) Restructuring of FSFs. The number of Financial Stability Commitees (formal or defacto), went from 11 in 2008 to 47 a decade later (with the vast majority including
their ﬁnance ministries, central banks, and pruden�al regulator in thesecommitees) 37b) The regula�on of systemically important ﬁnancial ins�tu�ons (SIFIs) including via
levies on large banks.
c) Adop�on of Basel III capital requirementsd) Miscellaneous other improvements including accoun�ng reforms; enhanced risk
management; improved transparency and repor�ng; improved resolu�onframeworks; stress tes�ng; and improved liquidity management.
By far, the most dis�nc�ve new tool in the policy toolkit used to reconcile price and ﬁnancial
stability has been the use of macropruden�al measures in both advanced and emerging
markets (Figure 8). 38 Macro-pruden�al measures now commonly used include: loan-tohtps://www.fsb.org/about/Edge, R. and Liang, N. (2019), “New Financial Stability Governance Structures and Central Banks,” Financeand Economics Discussion Series 2019-019. Washington: Board of Governors of the Federal Reserve System,
htps://doi.org/10.17016/FEDS.2019.019
38
Borio, C., Shim, I., and Shin, H. (2022), “Macro-ﬁnancial stability frameworks: experience and challenges”, BIS
Working Paper No. 1057, Dec 2022.
36
37

18

7 November 2023
value ra�os; debt service-to-income ra�os; debt-to-income ra�os; systemic risk surcharges;
housing taxes; reserve requirements (FX, domes�c currency and credit-growth based); limits
on FX open posi�ons; and countercyclical capital buﬀers. Liquidity requirements include theminimum liquidity coverage ra�o, the minimum net stable funding ra�o, the minimum liquid
asset ra�o and the maximum loan-to-deposit ra�o.
Figure 8: Macropruden�al Measures in Advanced Economics and Emerging Markets 39

A common (if not consensus) view is that macropruden�al policies are the primary tool for
addressing FSMs while monetary policy should focus on the inﬂa�on mandate. The
reasoning behind this view is that macropruden�al tools can be used in a targeted way tolean against the wind or support a speciﬁc segment where a bubble bursts (e.g., sectorspeciﬁc LTVs or capital requirements). In contrast, monetary policy is broad brush and thus
less eﬃcient if the ﬁnancial vulnerability is narrow; and cannot help to build resilience in thesame way as say high bank capital requirements.40
Those favouring a non-separable approach between monetary and ﬁnancial stability policy
stress the limita�on of macropruden�al policy, for example, to regulated segments or stressthe problem of whack-a-mole (where macropruden�al rules may push the problem into
unregulated sectors). Further, they argue monetary policy imposes costs on all segments andso does not involve introducing distor�ons between segments. Finally, monetary andmacropruden�al policies have similar transmission channels to the real sector so aﬀect eachother. 41

Ibid.
Adrian, T. and Liang, N. (2016), “Monetary Policy, Financial Condi�ons, and Financial Stability”, Federal
Reserve Bank of New York, Staﬀ Report No. 690, Dec 2016.
41
Ibid.
39
40

19

7 November 2023
The Fed 42, ECB 43 and BOE 44 might be well characterised by the view that monetary policy
should remain focused on price stability and other tools – macropruden�al andmicropruden�al policies – should address ﬁnancial stability. The BOJ might see more of arole for monetary policy over the medium term and also consider the build-up of bubbles,
given Japan’s experience with the prolonged a�ermath of bubbles burs�ng. 45
Advanced countries, in the post GFC period, have increasingly combined monetary andmacropruden�al policies. In par�cular, the loose monetary policy for the post-GFC and preCOVID period was combined with �ghtening macropruden�al policies (Figure 9).46 During
this period, large output gaps and low/stable inﬂa�on and some concerns about deﬂa�on,required accommoda�ve monetary policy which was thus constrained from “leaning”
against ﬁnancial imbalances; the use of macropruden�al measures consequently rose,par�cularly the use of risk-related capital buﬀers and housing/credit market focusedmeasures such as loan-to-value ra�os and debt-service-to-income limits. 47 With the onset of
COVID, interest rates and macropruden�al measures both eased sharply (Figure 9).
While macropruden�al measures are the increasingly deployed instruments of the standard
FSF, there are limita�ons to their eﬀec�veness and the links between monetary policy andﬁnancial stability are clear. Borio et al. (2022, previously cited) note:
There is a consensus that keeping interest rates low for long contributes to risk-taking
and the build-up of ﬁnancial vulnerabili�es as well as having broader side eﬀects.
And it is becoming increasingly clear that the issue is not so much “leaning against
the wind” once signs of ﬁnancial imbalances become apparent – by then it is too late– but adop�ng a policy that takes ﬁnancial factors systema�cally into account.
The challenge is how systema�cally to integrate considera�on of ﬁnancial stability intoexis�ng monetary policy frameworks. Flexibility in the horizon of the price stability mandate(e.g., with the Fed move to average inﬂa�on targe�ng and Japan’s adop�on of a long run
inﬂa�on target) seems to be one dimension of providing increased degrees of freedom.
There is also increasing research considering the interac�on of monetary andmacropruden�al policies (with diﬀering evidence on the complementary or subs�tutability),“…focusing monetary policy decisions on macroeconomic objec�ves and using other tools for ﬁnancial
stability is likely the most prudent path.”, speech by Michael Barr (Fed Vice Chair for Supervision), Monetary
Policy and Financial Stability, October 2, 2023.
htps://www.federalreserve.gov/newsevents/speech/barr20231002a.htm
43
See ECB monetary policy strategy review cited earlier, or speech by Isabel Schnabel (Execu�ve Board of ECB),
Monetary and ﬁnancial stability – can they be separated?, 19 May 2023.
htps://www.ecb.europa.eu/press/key/date/2023/html/ecb.sp230519~de2f790b1c.en.html
44
See Speech by Sarah Breeden (BOE Financial Policy Commitee), “Two sides of the same coin – delivering
monetary and ﬁnancial stability �melessly”, 9 March 2023.
htps://www.bankofengland.co.uk/speech/2023/march/sarah-breeden-speech-on-macro-pruden�almonetary-policy-interac�ons-at-leeds-university
45
Miyao, R. (2011), “A Macropruden�al Perspec�ve in the Conduct of Monetary Policy”, Speech by Miyao(Member of the Policy Board) at Asian Economic Policy Conference, November 2011.
htps://www.boj.or.jp/en/about/press/koen_2011/data/ko111202a.pdf
46
Borio et al (2022) cited above.
47
Ibid.
42

20

7 November 2023
including recent empirical evidence that eﬀec�veness of macropruden�al policies may beenhanced in an inﬂa�on targe�ng regime. 48
Figure 9: Policy Rates, Bond Yields and Macropruden�al Measures in Advanced Economies

Lhs: — Policy rate; — 10-year government bond yield.
Rhs — Cumula�ve macropruden�al policy ac�on2
Notes: 1. Simple average of DE, ES, FR and IT; 2. Cumula�ve sum of �ghtening (+1) and loosening (‒1) ac�ons
For the four euro area countries, the average value of the cumula�ve sum for each country.

Source: From Borio et al (2022), previously cited.

Belkhir. M, et al (2023), “Macropruden�al Policy and Bank Systemic Risk: Does Inﬂa�on Targe�ng Mater?”,
IMF Working Paper WP/23/119, June 2023.

48

21

7 November 2023

Sec�on 3: The global inﬂa�on shock of 2021-23
In this sec�on we describe the main causes of the global inﬂa�on shock over the period2021-23, the response from central banks in the major western economies, and how this has
been subsequently cri�qued. We also discuss some of the lessons the whole experience
may hold for the design and opera�on of the consensus monetary and ﬁnancial stability
frameworks set out above.

Ways of viewing the causes of the shock
Figure 10 below shows the consumer inﬂa�on rates in the US, eurozone, Japan and UK overthe period of the pandemic. Ini�ally inﬂa�on remained very low, but from early 2021 in the
US and mid 2021 in the other countries it picked up rapidly.
Figure 10: Headline CPI Inﬂa�on – Germany, Japan, UK, US, EA

Source: FRED database; World Bank Inﬂa�on Database; Bank of Japan

There are a number of ways to view the causes of this sudden inﬂa�on surge. While theseessen�ally describe the same set of events and underlying processes, the diﬀerent
perspec�ves may give insights as to the authori�es’ response and any underlying policy
errors.
Unexpectedly strong demand and constrained supply
The combina�on of higher-than-expected demand with unexpected constraints on supply isperhaps the most popular and straight forward way to explain the post-pandemic inﬂa�on
shock.
22

7 November 2023
On the demand side, a key driver of inﬂa�on was the way consumers, whose income during
lock down was maintained by unprecedented government ﬁscal packages, switched
consump�on spending from services (where they were constrained by Covid-19 restric�ons)
to goods.
The resul�ng impact on prices was ampliﬁed by further shi�s in the composi�on of demand(e.g., to electric vehicles), new economic security-driven supply restric�ons (e.g., on the saleof advanced chips to China) and other ineﬃciencies in global supply chains as they
recovered from pro-longed shutdowns due to Covid-19. (These are illustrated in Figure 11
by the very sharp rise in shipping costs between the start of 2021 and the start of 2022.)
Figure 11: Indices of Shipping Costs During the COVID-19 Pandemic (Jan 2019=100)

Source: Carriere, Y. et al. (2022), IMF Working Paper WP/22/61

The combined result was a sharp rise in goods inﬂa�on which peaked in the US in Q1 of
2022.

23

7 November 2023
Figure 12: US PCE Inﬂa�on – Goods, Services and Overall

Source: US Bureau of Economic Analysis

A further demand-side factor, especially in the US, was the boost to demand caused by aseries of very large ﬁscal s�mulus packages. The ﬁrst of these took place in 2020, but they
were renewed several �mes, amoun�ng to $5tn over the period of the pandemic as awhole, and including some $1.9tn of direct payments to individuals and families. 49
On the supply side, Covid 19-linked deaths and long-term illness had a major eﬀect on
labour supply in some countries over varying periods. For example, by autumn 2022, nearly
0.5 million people were thought to be “missing” from the US labour market. 50 Meanwhile in
the UK, the number of economically inac�ve workers was es�mated to have increased by
400,000 at the start of 2022 compared with before the pandemic. 51 The later situa�on
con�nues.
Constraints on energy supply have also played a major role in the inﬂa�on shock. Prices
were boosted by a pick-up in interna�onal crude oil and natural gas prices in the second halfof 2021 linked to fears of supply constraints underpinned by tensions between Ukraine andRussia as well as increasing prospects for economic recovery.
Parlapiano, A., Solomon, D., Ngo, M., Cowley, S. (2022) ‘Where $5 trillion in Pandemic S�mulus Money
Went’, New York Times, 11 March 2022, htps://www.ny�mes.com/interac�ve/2022/03/11/us/how-covids�mulus-money-was-spent.html
50
Luscombe, R. (2022) ‘Covid caused huge shortages in US labor market, study shows ’, The Guardian, 13.
September 2022, htps://www.theguardian.com/us-news/2022/sep/13/us-labor-shortage-long-covid
The labour force par�cipa�on rate fell from 63.3 percent in January 2020, to a nadir of 60.1 percent in April
2020 and has been increasing since but s�ll only reached 62.8 percent in September 2023 (US Bureau of Labor
Sta�s�cs).
51
BBC News (2022), ‘Where are Britain’s missing million workers’, 28 January 2022,
htps://www.bbc.co.uk/news/business-60039923
4924

7 November 2023
Then from late February 2022, inﬂa�on in Europe received a further very strong boost
following Russia’s atack on Ukraine and the subsequent 80% cut in supplies of Russian
natural gas to the European market in retalia�on for G7 economic and ﬁnancial sanc�ons.
The Dutch TTF gas futures price peaked at euros 277 per megawat hour on 22 August 2022.
This was nearly four �mes its level just before Russia’s full-scale invasion of Ukraine, andmore than 15 �mes its level at the start of 2021.52
Although, the Russian cut-backs in gas supply were limited to the European market (Russia
did not for example impose constraints on supplies to Japan) and some of the supply that
had previously gone to Europe was diverted to India and China, there was nonetheless aripple eﬀect on global gas prices around the world as European consumers sought to makeup some of the shor�all from alterna�ve suppliers.
Many advanced governments so�ened the immediate impact of these price rises on theirdomes�c consumers, and to some extent commercial consumers, through large ﬁscal
subsidies, the resul�ng feed through into consumer prices was nonetheless a substan�alboost to inﬂa�on over 2022.
The war in Ukraine also had a major impact on world food prices. Wheat prices nearly
doubled in the immediate a�ermath of the invasion and stayed high un�l an agreement wasreached to open an export corridor to allow some of the grain trapped by the war to moveto the rest of the world.
Figure 13: Global Wheat and Fuel Prices

Source IMF World Economic Outlook Database, October 2023

Sta�sta (2023), ‘Dutch TTF gas futures at the beginning of each week from January 4 2021 to August 28 2023’,
htps://www.sta�sta.com/sta�s�cs/1267202/weekly-dutch-�-gasfutures/#:~:text=Dutch%20TTF%20is%20seen%20as%20a%20Europewide%20natural,hour%20following%20the%20outbreak%20of%20the%20Russia-Ukraine%20war.

52

25

7 November 2023
This mix of demand and supply factors can plausibly explain the strong inﬂa�onary pressuresbuilding in 2021-22. However there remains the ques�on of why central banks did notintervene to limit the size of the inﬂa�onary shock that emerged from these factors.
Excessive monetary growth
Another way to look at the cause of the inﬂa�on shock is to view it as a monetaryphenomenon.
Figure 14: Change in G20 Deﬁcits, 2020 (percent of GDP)

According to this view, the massive deﬁcits run by the major developed economies during2020 (see Figure 14) resulted in huge funding requirements that were substan�ally met bycentral banks buying government bonds and other assets (Figure 7 and Figure 15).

26

7 November 2023
Figure 15: Central Bank Purchases of Government Debt during 2008-2020(% of central government marketable securi�es or debt issued since 2020)

This was done under the labels of QE and liquidity support. But such purchases ofgovernment bonds were observa�onally equivalent to debt mone�sa�on, or prin�ng
money; the main diﬀerence was the intent of the purchases, namely monetary easing versus
debt ﬁnancing. (Some emerging economy central banks also undertook asset purchases,
through they were not typically at the ZLB/ELB at the �me, sugges�ng that the mo�va�on
was more public ﬁnancing than monetary easing.)
A key diﬀerence in the way QE took place during the pandemic, as compared to theexperience of the GFC or Japan (post 2000), was the very rapid pace of bond purchases andthe extent of broad money growth associated with this. The US saw unprecedented M2
growth at the start of the pandemic in early 2020 (Figure 16). 53 The UK, Euro Area andJapan also saw a sharp pick up in M2 growth at that �me.

Post GFC, the growth in the monetary base did not translate into growth in broader money as banks and theprivate sector de-leveraged and strengthened balances sheets, but in 2020 we did see both reserve moneyand M2 expand rapidly as credit was needed by the private sector to survive and the ﬁnancial sector was inmuch beter shape to support credit expansion.
53

27

7 November 2023
Figure 16: US M2

It is also notable that central banks con�nued with QE even a�er inﬂa�on began to rise. In
the UK bond purchases con�nued to the end of 2021 by which �me inﬂa�on was alreadywell above target at over 4%. Similarly the US Federal Reserve undertook its last round of
QE in March 2022, by which �me headline inﬂa�on was approaching its peak of 8%.
In hindsight it is seems highly likely that this very rapid monetary growth contributed to theinﬂa�on shock and that the QE was con�nued for too long.
Rapidly closed output gap
A further way to view the 2021-23 inﬂa�on shock is as the outcome of an “output gap”
economic model. In this case, inﬂa�onary pressures are correlated with the size of theoutput gap, which is deﬁned as the diﬀerence between actual and poten�al economic
outputIMF (October 2023 WEO) es�mates suggest there was a large nega�ve output gap in boththe US and UK through much of the post-GFC period (Figure 17). This was in substan�al partcaused by the damage that the GFC caused to domes�c ﬁnancial systems. The nega�ve
output gaps gradually closed and by 2019 had almost disappeared.

28

7 November 2023
Figure 17: Output Gaps

Source: IMF World Economic Outlook, October 2023

The pandemic saw a sharp re-opening of the gap, but the extent was much smaller than in2010 reﬂec�ng the massive monetary and ﬁscal policy response and poten�ally the diﬀerent
nature of the shock. The gap then closed very quickly and became signiﬁcantly posi�ve in
2021 with the V-shaped recoveries associated with opening up and the release of pent-up
demand and big savings buﬀers (including due to the ﬁscal transfers). The inﬂa�on shockmight therefore reﬂect a situa�on in which the monetary authori�es either overes�matedthe size of the gap caused by the pandemic, or underes�mated the speed with which it
closed.
The analysis above of the three ways of looking at the causes of the 2021-23 inﬂa�on shock
seeks to provide a stylised response to the ques�on “what caused the shock”. However, it
clearly does not capture some of the country-speciﬁc structural factors that determined theinﬂa�on picture in individual countries.
Thus Japan’s “output gap” experience was very diﬀerent to the US and the UK in so far as it
did not have a strongly posi�ve output gap in the post-GFC period (Figure 17). Moreover,the gap that opened up following the pandemic closed rela�vely slowly (according to IMF
es�mates). In addi�on, in contrast to the other countries, the UK faces con�nuing, and tosome degree permanent constraints on its supply channels due to Brexit. Similarly, the factthat Germany is currently one of the weaker eurozone economies means that the risk of
intra-eurozone ﬁnancial strains during the rapid build-up in interest rates has been reduced.

The central bank response
Central banks typically did not begin raising their policy rates in response to the emerging
inﬂa�onary pressures un�l 2022 despite long-term inﬂa�on expecta�ons (in the form of 529

7 November 2023
year and 10-year breakeven inﬂa�on rates derived from inﬂa�on index linked debt) rising
rapidly beforehand (Figure 18). Average inﬂa�on expecta�ons over ﬁve years increased
from around 1.7 percent pre-Covid to a peak of around 3.3 percent) in Spring 2022.
Figure 18 US Inﬂa�on Expecta�ons and Fed Funds Rate

Source: FRED Database

Moreover central bank communica�ons argued that the various shocks would be transitory
well into summer 2022, with QE con�nuing beyond that
There are several possible explana�ons for the delay.
For example, some policy makers believed (not unreasonably) that the constraints on goods
supply chains and energy price shock would be transitory. They also believed that consumer
inﬂa�on expecta�ons would be s�cky following such a long period of price stability and nearzero interest rates. In this case they thought they would be able to allow the ﬁrst-roundeﬀects from the energy price rise, but did not need to raise rates simply in order to head oﬀ
possible second round eﬀects.
Other policy makers also focused on the impact of energy price rises (even a�er government
subsidies) on disposable income and were concerned that this would depress wider
economic ac�vity, reducing the pass through from price rises, but also raising the risk that an
excessively strong response to the price shock would push the economy into recession.
Against this background, two main cri�ques have been made of the approach taken by
central banks in their approach to controlling inﬂa�on.

30

7 November 2023
The ﬁrst relates to their handling of the pandemic shock itself. There is no ques�on that
there was enormous uncertainty about the economic implica�ons of the pandemic when it
ﬁrst hit in March 2020.
It was a completely unprecedented event, and the oﬃcial response evolved rapidly. Central
banks had to judge the impact on business and consumer conﬁdence (depressing demand),and the eﬀect of combining oﬃcial measures to lock down ac�vity (restric�ng supply andrepressing demand) with massive public sector ﬁnancial support to households (boos�ng
demand). The scale of the later programmes was much greater than in the GFC – equivalent
to some 10% of GDP compared with 2%. There were poten�al eﬀects on both the demandside and supply side of the economy. And it was ini�ally far from clear what the net eﬀectwould be on employment, produc�on and demand, and how these eﬀects would be spread
across diﬀerent sectors.
Central banks also had to judge how eﬀec�ve in these circumstances their core policy
instruments of short-term interest rates (which in most cases were already very close to thelower bound) and QE would be.
Given the very sharp ini�al falls in debt and equity prices when the crisis ﬁrst hit, it wasunderstandable that central banks chose in the short term to try and boost conﬁdence bypushing interest rates as close possible to zero and stepping up QE.
But some commentators argue that central banks were at fault because they con�nued withthese policies a�er it became clear what the main impacts of the pandemic would be, i.e.
that consumers’ ability and desire to spend would be maintained, but Covid restric�ons
would limit for a �me their ability to do so because of supply restric�ons on both services
and goods. This led to a build-up of liquidity in the economy, and it should not, according tothis view, have surprised central banks that this led to surging demand as soon as sectors
began to re-open – ini�ally goods, but subsequently also services, such as entertainment
and travel. 54
Other commentators accept that there was considerable uncertainty, even in latesummer/autumn 2022, about the future course of inﬂa�on in advanced economies, but that
central banks should have been much more risk averse about the possibility that transitory
shocks could become embedded in inﬂa�on expecta�ons. This was par�cularly so in thecontext of the pandemic which had made some of the most important data - such as theac�ve work force - harder to interpret.
Linked to this, commentators have also cri�cised central bank communica�ons strategies,
sugges�ng that they have put too much weight on being seen to deliver on commitments
made in previous communica�ons statements and forward guidance, even though new
circumstances had emerged that were not allowed for in the original framing of thestatements.

Instead, at least on central bank that had not yet implemented nega�ve base rates was preparing the groundfor this as late as spring 2022.
54

31

7 November 2023
By way of illustra�on, in his Jackson Hole speech in August 2021, 55 Fed Chair Jerome Powellset out the historical experience of the disadvantages of responding to all transitory shocks,
and also the fact that even transitory shocks could have permanent eﬀects on inﬂa�on.
He also reiterated the Fed’s forward guidance, namely
We have said that we will con�nue to hold the target range for the federal
funds rate at its current level un�l the economy reaches condi�ons
consistent with maximum employment, and inﬂa�on has reached 2% andis on track to moderately exceed 2% for some �me.
But he then said that it was too soon for the Fed to start �ghtening policy because theeconomy was well short of full employment and there was too much uncertainty overwhether inﬂa�on would remain at permanently at or slightly above 2%. Arguably, however,the Fed’s forward guidance should have been reframed to take account of the considerable
upside inﬂa�on risks triggered by the war in Ukraine.
Similarly, one possible explana�on for the Bank of England con�nuing QE up to the end of2021, despite inﬂa�on reaching 5%, is that they did not want to contradict previous
guidance to the eﬀect that the Bank would undertake QE for the whole of 2021.
The second cri�que of central banks relates to the period between the global ﬁnancial crisisand the onset of the pandemic.
Again, it is accepted that the ini�al response of central banks to the GFC in cu�ng interest
rates very close to zero and beginning large-scale quan�ta�ve easing was jus�ﬁed by thescale and nature of the nega�ve shock to demand caused by the ﬁnancial crisis.
Subsequently, central banks also had to factor in the research evidence that crises driven by
the ﬁnancial sector had prolonged eﬀects. And they had to deal with the strong desire of
the ﬁscal authori�es in a number of economies (e.g., UK, Canada and Germany, though notUS) as soon as the immediate crisis had passed to consolidate their current spending andreduce debt rela�ve to GDP. This followed the sharp hike in debt/GDP ra�os caused by thecrisis as revenues were reduced and spending increased, in some cases linked to the costs oflarge ﬁnancial rescues.
However, it is also argued that central banks then maintained ultra-lose monetary policy for
substan�ally longer than was necessary and also did not take account of the likelihood that a
number of structural factors in the global economy - which were limi�ng the impact of thesevery high levels of liquidity on prices - would not last indeﬁnitely.
These included: the impact of US fracking and new Russian gas supplies in maintaining
downward pressure on global energy prices; the very low private sector ﬁnancing costs, inpart sustained by QE; and low manufacturing labour costs brought about par�cularly by

Powell, J. (2021), ‘Opening Remarks: Monetary Policy in the Time of Covid’, Kansas City Federal Reserve
Board, htps://www.kansascityfed.org/Jackson%20Hole/documents/8752/Powell_JH21.pdf

55

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China’s integra�on in the global economy following its WTO accession in 2001, but also theintegra�on of other emerging economies with rapid popula�on growth.
The par�al reversal of these factors since 2015 meant that at the point new drivers of
inﬂa�on began to build in late 2021, their impact on prices was further ampliﬁed by the
cumula�ve eﬀects of a decade of very loose monetary policy, and was not oﬀset by previous
disinﬂa�onary structural features in the global economy.
Some commentators argue that if central banks had been more alert to the way their veryloose monetary policy had interacted with structural economic change, they would haveacted quicker to prevent second round eﬀects from price rises becoming embedded.
A further cri�que has been made of the overall approach of the authori�es (central banks,
ﬁnance ministries and ﬁnancial regulators) to the ﬁnancial stability issues that arose during
the rapid build-up in short-term interest rates. This reﬂects a new situa�on created by the
pandemic.
At the outset of the pandemic, ﬁnancial ins�tu�ons would have faced enormous losses if
governments had not stepped in to support the ﬁrms in lock down that they had lent to by
paying salaries and providing loan guarantees etc. This was not surprising given the scale ofthe crisis and the enormous dead weight losses that would have occurred in the economy ifgovernments had not intervened.
However, it le� an unanswered ques�on, as to exactly how far commercial banks should be
required to prepare for massive shocks, such as the pandemic, through higher capital buﬀers
and more conserva�ve liquidity policies and other lending prac�ces.
The assump�on following the GFC was that ﬁnancial regula�on should aim for a situa�on inwhich private ﬁnancial ins�tu�ons either have suﬃcient capital of their own to withstand ashock, or could be wound down in such a way as to avoid a systemic crisis or losses to small
depositors.
But the pandemic introduced a new type of scenario and one which it would be impossible
to ask ﬁrms and their lenders to prepare for, because doing so would make their underlying
businesses unviable. This new type of scenario was further demonstrated during the energy
shock following Russia’s atack on Ukraine. Governments across Europe stepped in withenormous poten�al subsidies - thereby indirectly protec�ng their ﬁnancial systems because the consequences of not doing so would have been catastrophic for the economy.
The need for greater clarity, however, is illustrated by the US Spring 2023 banking crisis.
Silicon Valley Bank (SVB) SVB saw a large propor�on of its capital base eliminated during the
rapid rise in interest rates in autumn 2022 as a result of the maturity mismatch between
long-term, but risk-free assets, and short-term deposits. The bank’s plight was exacerbatedby the speed with which its deposits moved once the news got out, reﬂec�ng their size
(above deposit insurance level) and the connectedness of the depositors (heavily
concentrated in Silicon Valley).
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7 November 2023
SVB’s management made an extraordinary error in taking on the mismatched por�olio in
the ﬁrst place. And it is equally remarkable that the US regulatory system did not stop themfrom doing so. 56 However, a more fundamental issue has been raised by the response of
the US regulators. It is hard to argue that the SVB case matches the new scenarios for public
interven�on deﬁned by the pandemic and the European energy shock, and yet the US
authori�es chose to guarantee all the deposits in SVB, regardless of size, as well as those ofanother smaller bank, Signature Bank, which collapsed three days a�er SVB for broadly
similar reasons.57
SVB’s collapse was also partly responsible for the collapse and rescue of Credit Suisse a few
days later. While Credit Suisse’s circumstances were very diﬀerent, it was SVB’s collapse that
led to addi�onal scru�ny. A�er a long running series of management failures, the bankfound, in the face of market pressures brought on by SVB’s collapse, that it could not raise
the addi�onal capital it needed from its exis�ng shareholders. This led to a run by wholesale
depositors, leading the Swiss regulator and central bank to step in and force a merger with
UBS. The rescue ensured that all deposits were protected, but also led to the perverse
situa�on where holders of subordinated debt faced losses before shareholders werecompletely wiped out.
The size, complexity and poten�ally systemic nature, of Credit Suisse means that there waspoten�ally more jus�ﬁca�on to avoid wholesale deposit market losses than with SVB. But
having a clearer framework within which such decisions are made would s�ll be highly
desirable.

Board of Governors of the Federal Reserve System (2023), ‘Federal Reserve Board announces the resultsfrom the review of the supervision and regula�on of Silicon Valley Bank, led by Vice Chair for Supervision Barr’,press release, 28 April 2023, htps://www.federalreserve.gov/newsevents/pressreleases/bcreg20230428a.htm
57
Federal Deposit Insurance Corpora�on (2023), ‘FDIC Releases Report Detailing Supervision of the Former
Signature Bank, New York, New York’, press release, 28 April 2023, htps://www.fdic.gov/news/pressreleases/2023/pr23033.html
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Sec�on 4: Other factors that should be factored into a review ofmonetary policy frameworks
In the previous sec�on we reviewed the experience of the 2021-23 global inﬂa�on shock
and iden�ﬁed a number of possible areas in which the experience of the shock suggests a
possible need for a change in the monetary policy framework and/or the way it is operated.
These include; the need to reconsider the way forward guidance is framed and condi�oned
to ensure that it does not become a trap for policy makers; the possible need for central
banks to be more risk averse about scenarios under which transitory price shocks may
become embedded in long-term inﬂa�on expecta�ons; and the need for greater clarity on
the extent to which ﬁnancial regulators should atempt to make ﬁnancial ins�tu�ons
capable of dealing with economic "mega shocks” rather than relying on very large scale
government interven�on.
This sec�on considers whether there are other issues on the horizon that should beconsidered at the same �me.
The structure and behaviour of the world economy is constantly evolving and monetary
policy makers respond to this by developing new forecas�ng models or upda�ng exis�ng
ones, deploying new data sources and gradually changing their opera�ng assump�ons andguidelines based on research. Examples of the later are the period over which the shortterm interest rate is expected to have its primary eﬀect on inﬂa�on, or the way in which the
pass-through to inﬂa�on from external shocks will be handled (ﬁrst-round and second-roundeﬀects). Certain trends, such as the growth of on-line retailing and the impact of the shi� toworking from home or changing demographics on the labour market 58 can be handled inthis way as, perhaps, can the implica�ons of rapid innova�on in the ﬁnancial system
including development of new banking services through ﬁntech.
However, there are four economic and poli�cal trends on the horizon – and in some cases
already impac�ng the way the global economy func�ons - which we would argue require adiﬀerent treatment. This is essen�ally because the impact they could have on the way the
global economy func�ons, or on the poli�cal underpinning of the current monetary
framework, is of such an order that a gradual evolu�on in opera�ng methods of the typedescribed above is unlikely to work. Instead, monetary authori�es should research as far as
possible the implica�ons of these trends now and, if necessary, take ac�on now to prepare
their opera�ng frameworks for the changes to come.
The four trends that we think should be treated in this way are:-the trend to fragmenta�on in global markets for goods, services, capital and labour;
the prospect of more frequent and much more extreme natural and man-madeshocks;Goldberg, E. (2023) ‘What We Know About the Eﬀects of Remote Work’, The New York Times, 17 October
2023, htps://www.ny�mes.com/2023/10/10/business/remote-work-eﬀects.
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7 November 2023-

the need for very high levels of public investment to meet the needs of the net zerotransi�on and other existen�al threats to mankind and their implica�ons for public
debt and debt distress;
the impact of extremism and polarisa�on on the poli�cal underpinning for central
bank independence.

The implica�ons of these trends and the policy responses are closely inter-related. Below
we consider each in turn and then atempt some overall conclusions.
Fragmenta�on in global markets
The past ﬁve years have seen a reversal in the long-standing trend towards increasing
interna�onal integra�on of markets for goods, services, labour and capital. There are threemain drivers for this.
Firstly, there is now a more nega�ve view in the west, and par�cularly in the US, of theeconomic impact of globalisa�on and of China’s 2001 accession to the WTO. President
Trump responded to this mood by imposing 25% tariﬀs on $34bn of Chinese exports in July
2018. This followed an early decision in March to impose 25% tariﬀs on nearly all US steel
imports (including Chinese) 59. The Trump Administra�on also eﬀec�vely paralysed the
WTO’s ability to setle trade disputes by refusing to approve replacement judges for its
dispute setlement appellate body. President Biden has maintained - and in some instances
strengthened - the Trump Administra�on’s measures against China. It is also likely that the
US is breaking WTO rules by oﬀering, through the Inﬂa�on Reduc�on Act, very large
subsidies to US (but not foreign) companies making “green” goods that will help deliver net
zero.
Figure 19 shows the build-up in the annual volume of trade and investment restric�ons
worldwide since the GFC. The ini�al focus was almost en�rely on trade in goods, but new
restric�ons on services trade and investment are becoming increasingly common.

BBC News (2023), ‘Trump puts 25% tariﬀ on Chinese Goods’, BBC News, 15 June 2028,
htps://www.bbc.co.uk/news/business-44498484

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7 November 2023
Figure 19: Trade Restric�ons

A second factor has been rising geopoli�cal tensions between the West and China. This has
been driven by concern in the US over China’s military build-up, China’s military
encroachment on Taiwan and China’s support for Russia following its atack on Ukraine. It
has been accompanied by a series of US moves to restrict the export of high-tech goods,
par�cularly semiconductors, to China, as well as �ghter restric�ons on Chinese investmentin the US and on US private equity capital ﬂows to China.
Thirdly, Russia’s atack on Ukraine has led to considerable disrup�on in regional trade ﬂows,
but even more importantly, it led the G7 to undertake unprecedented economic andﬁnancial sanc�ons against Russia. The later have been designed to weaken Russia’s ability
to con�nue the war by excluding it from the interna�onal ﬁnancial system (including
through such steps as excluding most Russian banks from the interna�onal payments systemand freezing $300bn of Russian central bank reserves), by restric�ng its access to key
business services and high technology goods, and by limi�ng the revenue it is able to raisefrom hydrocarbon exports through an “oil price cap” banning the provision of commercial
services for oil shipments priced above $60 per barrel. While these measures were
speciﬁcally targeted on Russia, they will have led other countries to be concerned that thesame measures could be applied to them under certain circumstances; they will therefore
have a broader eﬀect on fragmenta�on.
There is some debate among experts over the extent to which there is already evidence ofmarket fragmenta�on. For example, bilateral trade ﬂows between the US and China

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reached an all-�me high of $690.6 in 2022. 60 However, Figure 20 shows that the tradeintensity of world GDP appears to be trending down since the GFC. Moreover, a recent study
by the WTO suggests that trade ﬂows among poli�cally aligned countries are now growing
between 4-6% faster than those between non-aligned countries. 61
Figure 20: Global Trade (% of GDP)UNCTAD’s latest World Investment Report also recorded a drama�c fall (of nearly 37%) in
FDI received in developed economies in 2022 compared with 2021.62 This follows a sharp
rebound in total FDI in 2021 following the pandemic. But the latest ﬁgure would support theview of some experts that the forces driving fragmenta�on will have a bigger impact inglobal capital markets than on trade in goods and services.
In its spring WEO 63, the IMF es�mated that barriers to the free ﬂow of foreign direct
investment linked to the fragmenta�on of the global economy into geopoli�cally aligned
blocks could lead to a cumula�ve reduc�on in global output of 2%.
As men�oned earlier, the reversal in globalisa�on was arguably already one of the factors
contribu�ng to policy errors underpinning the 2021-23 inﬂa�on shock. But it is likely also tohave signiﬁcant consequences for monetary policy going forward.
First, by placing restric�ons on the extent to which capital can move from one country toanother, it will lead to a less eﬃcient overall alloca�on of capital interna�onally and makeWorld Trade Organisa�on (2023), World Trade Report 2023: Re-globalisation for a secure, inclusive andsustainable future, World Trade Organisa�on,
htps://www.wto.org/english/res_e/booksp_e/wtr23_e/wtr23_ch2_e.pdf
61
Ibid.
62
UNCTAD (2023), World Investment Report 2023, UNCTAD, htps://unctad.org/publica�on/world-investmentreport-2023
63
International Monetary Fund (2023), World Economic Outlook April 2023: A Rocky Recovery, IMF,
https://www.imf.org/en/Publications/WEO/Issues/2023/04/11/world-economic-outlook-april-2023
60

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the global economy less resilient to major shocks. Second, it is likely to increaseinterna�onal investors’ concerns that their exis�ng assets may become stranded as a resultof sudden shi�s in government policy - such as the Trump Administra�on’s tariﬀs on steel
imports.
One of the net eﬀects will be to reduce overall trend growth, which in itself might notrequire any an�cipatory ac�on by central banks. However, the prospect of sudden
restric�ons on capital ﬂows linked to geopoli�cal developments may require central banks todevelop new surveillance connec�ons and capabili�es and possibly even new lending
facili�es to enable them to target support on speciﬁc ﬁrms or sectors. The ﬁrst step is towork through the most likely scenarios and scope out what might be needed.
Extreme Shocks
The global ﬁnancial crisis (GFC), the pandemic, and Russia’s atack on Ukraine have all insome respects been unprecedented and have had global economic consequences on anenormous scale. Extreme weather events linked to climate change, and agricultural shocks
linked to biodiversity loss also appear to have the poten�al to cause global economic shocks
on a similarly enormous scale in the near future.
Some of these shocks are essen�ally man made (such as the GFC and Ukraine war) andwhile it is possible that they may increase in scale and frequency in the future, there is noautoma�c reason why this should be the case. However, in the case of shocks caused byclimate change, infec�ous disease and biodiversity loss, the science suggests that, in theabsence of radical (and early) government interven�on on a global scale, they will increasein both frequency and scale. This reﬂects both the underlying causes - such as accumula�onof greenhouse gasses (GHGs) in the atmosphere, or human encroachment on animal
habitats - but it may also be exacerbated by a growing disconnect between the outlook asseen by scien�sts and that seen by ﬁnancial market par�cipants. 64 Rather than adjus�ng
gradually to the worsening scien�ﬁc outlook, ﬁnancial markets may adjust suddenly.
Monetary policy globally has already played a central role in response to the GFC and the
pandemic and will be expected to do so again in response to future global economic shocks.
While economic policy makers could wait un�l the shocks occur before formula�ng a
response, it would clearly be beter for them to think through in advance what might berequired and if appropriate make the necessary facilita�ng changes in the monetary policy
framework. The cri�que of monetary policy during the pandemic illustrates the dangers of
having to deal with an en�rely new situa�on without prepara�on, as well as the risk thatpolicy makers will fall into a one size ﬁts all response.
Key ques�ons include:- how frequent and how large are future “mega” shocks likely to be?

Butler, C. (2023), ‘Climate change threatens to cause the next economic mega-shock’, Chatham House Expert
Comment, 20 July 2023, htps://www.chathamhouse.org/2023/07/climate-change-threatens-cause-nexteconomic-mega-shock
64

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what will be the op�mal monetary policy response with respect to each type ofshock, and how will this interact with complementary ﬁscal and pruden�al policy
responses?
are new approaches to coordina�ng monetary, ﬁscal and pruden�al policy required
to deal with poten�al shocks?
how might the central bank reac�on func�on need to be modiﬁed to take account of
the likelihood of sequen�al mega shocks. For example, will the authori�es need torestore short-term interest rates to the long run average se�ng much sooner thanthey might otherwise wish to do (and notwithstanding underlying economic
weakness in the economy) in order to maintain an eﬀec�ve policy response to newshocks? Or should the inﬂa�on target be increased (to reduce the risk of hi�ng theELB) and should ﬂexible average inﬂa�on targe�ng be adopted to provide greater
ﬂexibility in monetary policy.
to what extent should economic policy makers require private individuals and ﬁrms
to take pre-emp�ve ac�ons, e.g., by limi�ng foreign currency public and private debt,
by requiring sovereign debt to incorporate climate resilience clauses, or by imposing
new (mandatory) climate risk disclosure policies?
what kind of data, modelling and forecas�ng tools will be necessary to deal withthese circumstances?
are there any new instruments that central banks, ﬁscal authori�es or ﬁnancial
regulators need to develop pre-emp�vely?

Research is already underway in universi�es 65 and some central banks and ﬁnance ministries
on how to model an economy subject to repeated very large shocks. There is also growing
evidence that some ﬁnancial market par�cipants - par�cularly in the insurance sector - arebeginning to take decisive steps in response to the growing incidence of extreme weather
events. 66
However, the research needs to be speeded up with expanded scope and clear focus on theimplica�ons for policy instruments. Other poten�al steps include devising and applying
more extreme stress tests. However, as discussed earlier, this will only make sense for verylarge shocks if there is ﬁrst greater clarity on the role that governments will play and how
much risk private ﬁnancial ins�tu�ons will be accepted to absorb.
Global investment gap
Es�mates vary, but there is litle doubt that the world, as a whole, faces an enormous
investment gap. UNCTAD recently es�mated that the ﬁnancing gap to meet the Sustainable
Development Goals (SDGs) had now reached $4tn pa (over 6% of world GDP) between now
and 2030, up from $2.5tn pa when the goals were ﬁrst launched in 2015. 67

Cohort 2040 (2023), ‘How can we secure a beter world even as environmental destabilisa�on grows?’,
htps://www.cohort2040.org/
66Holder V. and Thomas N. (2023), ‘How investors are underpricing climate risks’, The Financial Times, 17
August 2023, htps://www.�.com/content/899472a8-e5e2-4fde-bc91-7e548ba35294
67
UNCTAD (2023), ‘SDG investment is growing, but too slowly’, SDG Investment Trends Monitor (Issue 4),
htps://unctad.org/publica�on/sdg-investment-trends-monitor-issue-4
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Some of this investment, while cri�cal to the quality of life of millions of people, could in
principle be delayed. But a signiﬁcant propor�on - notably that focused on ac�on tostabilize the climate, prevent a future pandemic or control the spread of an�-microbial
resistance – cannot be postponed as it is needed now to safeguard mankind’s future
existence. In par�cular, more than half of the total ﬁgure, or $2.2tn pa (3.5% of GDP), is
required for the energy transi�on to net zero. And, given the nature of the investment
needed, a substan�al part of this can only be met by public ﬁnance, including from themul�lateral development banks (MDBs) and other interna�onal sources.
The IMF’s latest Fiscal Monitor 68 sets out the enormous challenge facing both advanced anddeveloping economies in responding to the climate change challenge. The star�ng point is
far from ideal. Average net debt in the G7 is currently 96% of GDP and is expected to rise to103% of GDP over the next ﬁve years. The comparable ﬁgure in emerging and middleincome countries, is much lower, at 43% and 45%, but these countries typically have much
weaker borrowing capability (either domes�c or foreign) and are more vulnerable to debt
distress.
The IMF argues that while some countries (i.e., the US) have chosen to try and speed up
climate ac�on by using public funds to incen�vise green investment (through the Inﬂa�on
Reduc�on Act), simply borrowing more to meet the existen�al threat from climate change iseither unwise or likely to be impossible due to market constraints, for many countries.
Instead, the IMF proposes a mix of policies. These include some new public borrowing, butalso new carbon taxes and other measures to increase public revenues, elimina�on of fuelsubsidies (recently es�mated to be worth $7tn per year), and measures to incen�vise andimprove the environment for private ﬁnance. The precise mix of policies would vary fromcountry to country.
The IMF also highlights the cost of delay in tackling the net zero transi�on using thewidespread introduc�on of carbon pricing as a speciﬁc proxy for eﬀec�ve policy making.
Each year of delay in raising carbon prices is found to increase public debt by 0.8–2.0
percentage points of GDP in advanced economies.
However, while the IMF oﬀers a balanced and pragma�c way forward, the likelihood of thispolicy mix being adopted in full, at least in the short term is very low. This then raises theques�on of what the mix of policies will actually look like, what this will mean for the way
the global economy behaves, and how monetary authori�es should prepare to deal with
this.
There will be two main consequences of a failure to follow the IMF’s recommenda�ons:
First, delayed ac�on on mi�ga�on and adapta�on leading to larger and more frequent
extreme weather shocks, but also policy shocks as governments are ul�mately forced to takeradical ac�on. The pandemic has illustrated how radical governments in advanced
Interna�onal Monetary Fund (2023), Fiscal Monitor October 2023, Climate Crossroads: Fiscal Policies in a
Warming World, Interna�onal Monetary Fund,
htps://www.imf.org/en/Publica�ons/FM/Issues/2023/10/10/ﬁscal-monitor-october-2023

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countries are willing to be when faced with a clear existen�al threat. We have discussed
earlier the implica�ons of this for monetary policy frameworks.
Second, governments in both advanced and developing economies are likely to borrow morethan would be op�mal. This will reﬂect the addi�onal costs of delay in climate ac�on, as set
out by the IMF above. But it will also reﬂect the poli�cal obstacles they will face in raising
new taxes, transforming exis�ng ones and cu�ng subsidies. Borrowing more is a second
best op�on, but it is also the most likely one to be adopted.
In these circumstances, central banks will need to think carefully about the appropriatemonetary response, and in par�cular whether they view this type of borrowing as in somesense diﬀerent from other drivers of demand.
The borrowing will primarily be used to fund new public investment with three aims: toaccelerate the transi�on to net zero (primarily through investment in zero-GHG energy
sources, but also increasingly in other areas that are key to achieving net zero, such as foodproduc�on); to protect socie�es from the eﬀects of climate change that is already certain tohappen (ﬂood defences, new building design, etc.); and to ameliorate the social and welfare
costs of the above changes. This spending will partly take the form of subsidies (including
tax expenditures) for private business, and partly direct spending by governments(par�cularly on adapta�on which is harder to fund from the private sector).
The key judgement central banks will need to make is how far this spending will leave trend
growth in a given economy unchanged, and how far it will improve it, e.g., because some of
the new infrastructure does more than simply replace that which has had to be scrapped
ahead of its previously expected life �me due to its high carbon content, e.g., because it
accelerates the introduc�on of new, more produc�ve technology, or because it eliminates
costs, such as pollu�on.
The rela�on between this investment and r* is complicated. On the one hand the addi�onal
public and private borrowing may push up r* in the short term rela�ve to what it would
otherwise have been. But, if the investment that results does fundamentally improve
produc�vity, it could lead to a lower r* in the medium to long term.
Faced with this kind of uncertainty, the tradi�onal approach of central banks would be totake a cau�ous approach and wait to see how the new borrowing evolved, both in terms ofthe type of investment and its impact on produc�vity. However, the situa�on the world
faces over the next decade would arguably jus�fy a diﬀerent approach.
First, because of the scale of new investment that is needed, and hence the impact on
public borrowing. The order of magnitude will vary from country to country, but even inadvanced countries could be of the order of 2% of GDP pa on top of what would otherwise
have been envisaged. This means that the way central banks interpret what is happening
and the policy response they choose to make, will have a substan�al eﬀect on the outcome.
If they assume the addi�onal investment will have minimal, or no, impact on produc�ve
capacity, and set rates accordingly, this could unnecessarily choke oﬀ some of investment
needed to meet the climate challenge. In contrast to such situa�ons in the past, this would
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have signiﬁcant implica�ons for the future of the planet. Equally, if they are over op�mis�con the impact of this investment on produc�ve capacity, it could lead to further inﬂa�on
shock with all the consequences that entails. Either error has the scope to trigger a debt
trap scenario.
A second reason why the response of independent central banks, along with otherindependent ﬁscal authori�es, will be cri�cal is that through their communica�ons they will
help determine to how ﬁnancial markets view the addi�onal borrowing.
The experience of the very short-lived Liz Truss government 69 in the UK in Sept-Oct 2022
illustrates this. Following a so called “mini budget” on 23 September which announced £45
bn pa in permanent unfunded tax cuts, the largest one-oﬀ tax boost in the UK for ﬁ�y years,
a ferocious market reac�on led ini�ally to the resigna�on of the Chancellor, Kwasi Quarteng,and then a few weeks late to that of the Prime Minister herself. The budget had not beenassessed by the independent Oﬃce of Budget Responsibility, nor had the Bank of England
been consulted. At the same �me as announcing the unfunded tax cuts, the government
had also announced a much larger, but temporary, extension of support to households
aﬀected by the post Ukraine hike in natural gas prices. The cost of this was at the �mees�mated at £60bn, but atracted rela�vely litle aten�on from the markets.
The US authori�es have more freedom of ac�on on borrowing due to the economy’s size,
strength and the reserve currency status of the dollar, although the polarisa�on of domes�cpolicies and periodic ﬁghts over raising the federal debt limit complicates this. But - for thesame reason - the decision they make will have a global impact. Keeping US short-term
interest rates lower will enable other countries to do the same.
There are two further considera�ons that central banks will need to factor into their
response to the global investment gap.
First is how they head oﬀ the threat of a new period of ﬁscal dominance in which monetary
policy is formulated with a view to ensuring the country’s solvency, ahead of inﬂa�on andgrowth targets. This might occur if the combina�on of high debt (above 100% of GDP),
posi�ve real interest rates (at or above the long-term growth rate) and a return to low
inﬂa�on leads to rapid growth in the debt service burden. (Japan’s debt service alreadyaccounts for nearly one quarter of expenditure.)
Second, they will also need to consider what changes are needed in the way monetary,ﬁscal and regulatory authori�es coordinate policy. Central banks do not set monetary
policy in isola�on. Par�cularly at �mes of unprecedented and fast-moving shocks like thepandemic, they need to coordinate their ac�ons to preserve monetary and ﬁnancial stability
closely with ﬁscal authori�es and ﬁnancial regulators (when they are independently
cons�tuted). They need to maintain suﬃcient independence and freedom of ac�on to dowhat is required under their monetary policy mandates, while coopera�ng with otheragencies to achieve wider goals for the economy as a whole.
Par�ngton, R. (2022), ‘The mini-budget that broke Britain – and Liz Truss’, The Guardian, 20 October 2022,
htps://www.theguardian.com/business/2022/oct/20/the-mini-budget-that-broke-britain-and-liz-truss
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In view of the analysis above it will be important for central banks to work out - as far as
possible in advance - how they would view addi�onal net zero-linked borrowing and thenfactor the answer into their communica�ons, short-term interest-rate se�ng as well as
coordina�on discussions with the ﬁscal and regulatory authori�es.
Poli�cal polarisa�on
In the a�ermath of the global ﬁnancial crisis there has been a growing trend towards
poli�cal polarisa�on in some western and emerging economies. Examples include theelec�on of President Trump in 2016, the UK’s decision to leave the EU and the rise of the far
right in France and Germany.
One driver was the impact of the crisis itself in reducing produc�vity growth andcontribu�ng to higher income dispari�es between metro areas and poorly connected
regions within countries. Other factors include the impact of QE on asset prices, leading tohigher wealth inequality; the impact of trade liberalisa�on on some industrial sectors; therole of social media in crea�ng poli�cal echo chambers; large scale migra�on ﬂows;
opportuni�es for gerrymandering of electoral districts in the US; and, most recently, thedisparate impact of the 2021-23 inﬂa�on shock.
This trend has already had some impact on the independence of monetary authori�es, with,for example, Liz Truss calling for a review of the opera�onal autonomy of the Bank ofEngland in her campaign to be Conserva�ve Party leader, while in summer 2019 President
Trump put intense pressure on Jerome Powell to lower interest rates. 70 More recently, in
September, the Polish central bank made a surprise 75bp cut in interest rates, despite
con�nuing high inﬂa�on pressures, raising concerns that it was bowing to pressure to help
the conserva�ve government win upcoming polls. 71
The cons�tu�onal arrangements underpinning central bank independence vary enormously
from country to country, ranging from independence provisions enshrined in interna�onal
treaty in the case of the ECB through to the Bank of England’s opera�onal autonomy statutethat can be changed by a simple majority in parliament. However, in all cases a key
determinant of con�nued independence will be the extent of public support.
Some commentators argue that the pressure from populist poli�cs on central bankindependence will not let up and could intensify in the years ahead driven by poli�caldevelopments (e.g., if Donald Trump wins the 2024 US Presiden�al elec�on), but also by the

Mason, J. (2023), ‘Trump pressures Fed’s Powell: Let’s see what he does’, Reuters, 19 June 2019,
htps://www.reuters.com/ar�cle/us-usa-fed-kudlow-powell-idUSKCN1TK0CX
71
Gera, V. (2023), ‘Poland’s central bank surprises with sharp interest rate cuts despite double-digit inﬂa�on’,
Associated Press via ABC News, 6 September 2023, htps://abcnews.go.com/Interna�onal/wireStory/polandscentral-bank-cuts-key-interest-rate-despite-102961049#:~:text=WARSAW%2C%20Poland%20-%20Poland%27s%20central%20bank%20lowered%20its,party%20ahead%20of%20parliamentary%20elec�on%20s%20next%20month.
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public’s percep�on of con�nuing economic stress as well as the hit to central bank credibility
from the 21-23 inﬂa�on shock.
While central banks will not - and should not - make the ﬁnal decision on independence indemocra�c systems, there is much they can do to inﬂuence the debate in favour ofcon�nued independence. They should priori�se the following three areas:
First, restoring their credibility and reputa�on for competence by bringing current inﬂa�onpressures under control, including bringing inﬂa�on expecta�ons back to target as speedily
as possible.
Second, stepping up transparency by explaining the ra�onale for decisions, admi�ng
mistakes, and being ready to change course when the facts change and communicate clearly
the reasons for doing this. This will not be easy for some central banks and would run
against arguments to the eﬀect that central bank credibility can be re-enforced through adegree of inscrutability. This should also include a review of recent prac�ce in forward
guidance and may lead to a more risk averse or nuanced approach.
Third, engaging fully in academic and policy debates about the op�mum form and extent ofpolicy coordina�on between the monetary authori�es and other parts of government in theface of the new challenges facing the global economy. This should cover in par�cular the
essen�al features of policy coordina�on between central banks, ﬁnancial regulators andﬁscal authori�es in preparing for and responding to extreme shocks and emerging economic
security threats.
But it also needs to address the pros and cons of the diﬀerent ways in which central banks
can support government ac�on on climate change. 72 And given the urgency and existen�alnature of the climate threat to mankind, it should also consider whether in any areas policy
makers should be willing to trade oﬀ climate ac�on vs the central banks’ core mission ofprice stability.

Couto, L. (2023), How to boost international private climate ﬁnance, Research Paper, London: Royal Ins�tuteof Interna�onal Aﬀairs, htps://www.chathamhouse.org/2023/04/how-boost-interna�onal-private-climateﬁnance7245

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Sec�on 5: Implica�ons for the consensus monetary policy
framework and how it is operated
In this sec�on, we summarise brieﬂy the main implica�ons of the preceding analysis forreform of the consensus monetary framework, considering both the lessons from the 202123 inﬂa�on shock and the need to an�cipate key poli�cal and economic structural trends
that are underway in the world economy.
It is generally not advisable to change a policy framework in the middle of a crisis unless it
appears to be completely broken (which is not the case here). So the recommenda�ons
below are for adop�on once the immediate crisis linked to the inﬂa�on surge subsides.
Opera�ng the exis�ng monetary and ﬁnancial stability framework
Central banks should deepen their exper�se in geopoli�cal analysis and in other factors that
could underpin massive economic shocks in future (including extreme weather, biodiversity,
global health threats). Moreover, this work should be moved beyond a research focus (e.g.,in the NGFS) and be given an opera�onal dimension.
More speciﬁcally, central banks should expand their ability to model highly complex shocks(such as the pandemic) and to monitor diﬀerent dimensions to the shock on an on-goingbasis (e.g., through new data sources)
They should also make a renewed eﬀort at avoiding group think by diversifying their models,decisions makers, and encouraging outside challenge.
Central banks should be more risk averse when considering the possibility of pass-through tocore inﬂa�on of transitory shocks.
They should also review their approach to - and implementa�on of - forward guidance so as
to avoid the risk of being trapped by condi�onality that becomes out of date.
Changes to framework
Considera�on should be given to se�ng out much more clearly the division of responsibility
between public and private en��es in the event of a massive shock and deﬁning what thismeans for the ﬁnancial stability framework. This work should also look at the role ofmonetary policy as a shock absorber vs that of the ﬁscal and regulatory authori�es.
Considera�on should also be given to how to manage the risks associated with a muchlarger share of the net zero transi�on being ﬁnanced through public debt than might beideal. This should include: determining how to minimise the threat of ﬁscal dominance;
establishing what this should mean for the coordina�on mechanism between central banks,
ﬁnance ministries and ﬁnancial regulators; and looking at whether central banks may needto develop any new types of opera�onal facility.
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