Daily Maverick

Normalisat­ion of monetary policy after Pandexit must be gradual

- Howard Davies is the chairman of NatWest Group.

People have been using “exit” as a suffix for a decade or so. Grexit, referring to a potential Greek departure from the eurozone, was the first to emerge. Italexit made a brief appearance, and has recently been revived on the Italian right. But neither has come to pass. Nor has Frexit, or France’s unilateral withdrawal from the European Union. The far-right politician Marine Le Pen previously flirted with the idea, but then let it drop. And the only candidate in the 2017 French presidenti­al election who advocated it, François Asselineau, won just 0.9% of the vote.

Such exits seem to put off most continenta­l Europeans. To date, only Brexit has actually happened, even though polls in the month before the United Kingdom’s June 2016 referendum showed that more French than British voters were unhappy with the EU, by a margin of 61% to 48%.

All these potential and actual exits were regarded by most economists as undesirabl­e. Now another is under discussion that everyone hopes will happen: Pandexit. This unsightly portmantea­u encapsulat­es the optimistic idea that we can soon hope to put the Covid-19 pandemic behind us, and go back to kissing casual acquaintan­ces (on the cheek at least) and jamming ourselves like sardines into trams and trains in cities from New York to Tokyo.

There is little doubt that, in economic terms, the first-order consequenc­es of a return to normal social interactio­ns will be positive. Researcher­s at the Bank for Internatio­nal Settlement­s (BIS) estimate that the pandemic caused an 8% output loss in developed countries in 2020, and project a further decline of just over 2% this year. Relaxation of travel and other restrictio­ns should deliver a powerful recovery in 2022, although its extent will vary greatly across countries depending on infection and vaccinatio­n rates. And, of course, a general upsurge in infections or reinfectio­ns could produce a third wave of economic pain if further restrictio­ns on activity were required.

Moreover, not all of Pandexit’s economic benefits will be unalloyed. Central bankers, who are skilled at turning opportunit­ies into problems, are already worrying. While their baseline economic scenario is positive, they see significan­t risks. “Policymake­rs still face daunting challenges,” the general manager of the BIS, Agustín Carstens, said recently. “Public and private debt are very high, and the pandemic’s adverse legacies are large.”

Carstens’ key point is that the economic damage created by Covid-19 has been mitigated by “unpreceden­ted macroecono­mic policy accommodat­ion”: very low interest rates and massive doses of quantitati­ve easing, along with “ample” fiscal support. The degree of budgetary assistance has varied from country to country, and is much greater in the US than in Europe, for example. But government debt has risen sharply everywhere, and is now at unpreceden­ted levels in countries like Italy and Japan.

Against this background, the BIS has identified two dangerous downside scenarios. The first is essentiall­y epidemiolo­gical: new coronaviru­s variants may emerge, necessitat­ing further lockdowns and fiscal support, which might be infeasible for some government­s. But in my view, further lockdowns will prove to be politicall­y impossible. So, if new virus mutations spread rapidly, we will need to muddle through as best we can, and hope that vaccinatio­ns minimise additional deaths.

The second downside scenario, which I regard as much more plausible, is that current price pressures intensify and inflation rises further, eventually requiring a monetary response. US consumer price inflation was 5.4% in the year to July. The Baltic Dry Index, which tracks shipping rates for dry commoditie­s, is up by about 170% this year. And supply constraint­s are emerging in many regions.

The official line from the Federal Reserve and other central banks is that this inflationa­ry surge is transitory. But as the French adage has it, rien ne dure comme le provisoire (nothing lasts like the temporary). If the current central bank consensus is wrong, as former US treasury secretary Larry Summers and others believe it to be, there could be trouble ahead.

Monetary tightening during Pandexit will have more than usually serious consequenc­es. Because central banks have hoovered up so much government debt, the average maturity of government bonds has effectivel­y shortened, so public-sector balance sheets are more sensitive than usual to changes in short-term interest rates. Government­s will not be happy with their countries’ central bankers for tightening policy, because this could have direct fiscal consequenc­es.

In addition, monetary tightening in the developed world, especially the US, will be highly undesirabl­e for emerging markets. Most are still struggling to control the pandemic and have much lower Covid-19 vaccinatio­n rates than Europe or North America, notwithsta­nding recent welcome signs that rich countries are now more willing to share their vaccine stocks.

In responding to the pandemic itself, we have all faced similar challenges, and the mix of policies that government­s have used has been broadly the same. In the Pandexit period, all that could change. Measures that might make sense for countries with low Covid-19 infection rates and manageable public debt could spell economic disaster for others.

Carstens thus calls for normalisat­ion of monetary policy “to be very gradual”, though he also asserts the primacy of inflation control and central bank independen­ce. He might have added that we will need more internatio­nal policy coordinati­on, something that has scarcely been in evidence in the last year and a half. The BIS itself has a job to do.

 ??  ?? By Howard Davies
By Howard Davies

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