Gita Gopinath calls for new monetary policy thinking by economists

8 Mar 2023 , 11:16 AM

The year 2022 has been quite challenging for the global economies, including the Indian economy. Inflation was high, supply chain constraints continued and there were clear risks of a slowdown in growth amidst the Russia-Ukraine war. But as much as economies were challenged by these turn of events, the year has also been a major challenge to economists, economic policy and how monetary policy is conducted. 

In an interesting blog on the IMF website, Gita Gopinath, Deputy Managing Director of the International Monetary Fund , has underlined that economic policy and economists now need a new way of thinking. Perhaps, the old thinking on rates, jobs and growth may have either structurally changed or new relationships may have come about. Here are 8 very interesting insights pointed out by Gita Gopinath on how monetary policy needs to change and adapt to a new environment.

Why economists missed the inflation surge

In a sense, the bottom line is that majority of the economists missed the inflation surge of the last 15 months. It was not like the Global Financial Crisis of 2008. Everybody knew it was coming; they just did not know when it would come. In this case, most economists had been in the dark about the sudden surge in inflation globally. 

As Gita Gopinath, herself an economist of eminence, admitted; the truth is that economists missed the inflation surge and now we need to understand why they missed the trend. She also points out that the impact of macros like inflation, supply chain constraints and weak growth may last in emerging markets for much longer and hence it was essential to rethink assumptions. Clearly the pre-pandemic macro assumptions were wrong.

Pre-crisis assumption for post-crisis world

According to Gita Gopinath, one of the reasons for economists missing the surge in inflation is that they tried to apply pre-crisis assumptions to a post-crisis world. One of the big assumptions in macroeconomics is a flat Phillips Curve (an inverse linkage between inflation and unemployment). That relationship still holds, but its nature has changed structurally.

Most economists were used to a world where a rise in inflation accompanied with higher growth would lead to a minor fall in the unemployment levels. However, this time around, loose monetary policy led to unemployment falling much sharper. No economist had expected that the unemployment levels in the US would touch a 54 year low of 3.4%; or there would be only 1 job aspirant for every 1.9 jobs available.

Economists missed speed effect on Phillips curve

While the Phillips Curve relationship between inflation and unemployment still holds, Gita Gopinath is of the view that most economists had missed out the speed effect. Here is how it works. For instance, the rapid employment recovery may have played a significant role in driving inflation. What it could mean is that in the post-pandemic world, “speed effects” matter more than previously envisaged.

She also feels that an important factor missed out by most economists was the capacity constraints in the economies (what we saw in the case of semiconductor chips). The massive stimulus created a huge surge in demand but neither did companies have that much slack capacity, nor could fresh capacities come up at short notice. This combination had actually worsened inflation. 

Inflation risk from loose monetary policy, bigger than imagined

The global central banks experimented twice with excessive loose monetary policy. The first time it was post the global financial crisis in 2009 and the second was in 2020 to offset the effects of the COVID pandemic. Gita Gopinath believes that most economists had either underestimated or underplayed the ramifications of an ultra-loose monetary policy. 

For instance, it was believed that very low level of unemployment was a good thing, but it has been one of the biggest barriers to higher rates leading to lower inflation. A red hot economy driven by liquidity worked well for all the global economies. Ironically, at the end of the day, it was very low levels of unemployment that eventually spurred high inflation. 

Capacity constraints and supply shocks missed by economists?

We dwelt on this aspect briefly in the third point, but it deserves a more detailed treatment. The low unemployment level works well and good if the Phillips Curve is flat. The problem was that the Phillips Curve had turned non-linear in the last few quarters. Gita Gopinath points out that this is similar to what happened in the early 1970s when very low unemployment eventually led to very high levels of inflation. 

Specifically, on the capacity front, the problem started with key sectors which had hit capacity constraints. This was a classic case of demand struggling to keep pace with supply and the supply shortfall amplified the demand pull inflation caused by loose money. The challenge was not the supply shock but the fact that such supply constraints were deeper and were a lot more persistent. Also, in a globalized environment, constraints spread fast.

Need more aggressive policy response when economy is hot

In retrospect, Gita Gopinath admits that policy makers waited for too long to start shutting liquidity taps. Had rate hikes started in mid-2021, instead of early 2022, the situation may be different. Of course, that is hypothetical. One view is that central banks should react more forcefully under certain conditions; especially when economies are running hot on liquidity and consumer spending. 

Going ahead, policy responses may have to be calibrated. For example, central banks may have to be more aggressive in their policy responses in a strong economy when producers can easily pass on rising costs and workers have bargaining power. Central banks need a different approach for broad-based shocks.

High inflation de-anchors inflation expectations

One of the key assumptions in the success of monetary policy is that the inflation expectations are anchored to actual inflation rates. That means; central banks will have to be proactive and convince people that they would be willing to tighten to control inflation. The delay in commencing rate hikes, probably, de-anchored inflation expectations and that led to more inflation. 

In addition, the fears expressed by many economists, that too much hawkishness could lead to a slowdown in growth meant that consumers feared that central banks may change tack and become less hawkish. This de-anchoring was again something that most economists missed out, according to Gita Gopinath. What cannot be disputed is that high inflation de-anchors inflation expectations. This would largely complicate monetary policy trade-offs, making life for central banks more difficult.

Need for closer fiscal policy interaction

 Last but not the least, Gita Gopinath has underlined that stimulus of monetary and fiscal nature have to be synchronized. Most central banks did that briefly at the peak of the crisis, but not on a sustained basis. Central banks were obsessed with near-zero interest rates when inflation was anyways supposed to be low. Ideally, economists must reconcile to the reality of monetary policy having to stay tight for much longer. The gap has to be filled by fiscal policy targeted at the most vulnerable sections, without stimulating the economy. That may sound practically difficult, but that is the way forward.

It is indeed an honest analysts about the hits and misses of economists, by an eminent economist herself. Gita Gopinath has been one of the first to point out that economic thinking and economic policy needs to change its approach. A new normal does call for a new paradigm in the conduct of monetary policies.