A strong US dollar and high inflation were the main global macroeconomic trends of the year. In an interview with The Hindu, Eswar Prasad, professor at Cornell University and author of “The Dollar Trap: How the US Dollar Tightened Its Grip on Global Finance”, says that the rise of the US dollar reflects stronger economic fundamentals in the United States than in other countries. ‘other countries. great savings. It also discusses how Western central banks lost control of inflation, the economic costs of inflation, the future of central bank independence, and more.

How did the US Federal Reserve and other central banks in the developed world lose control of inflation that was relatively benign in recent decades?

The world has been hit by a series of supply disruptions that have proven to be quite persistent. This includes COVID-related disruptions to global supply chains (including the effects of China’s zero COVID policy), the Russian invasion of Ukraine, and a number of natural disasters. Economic theory clearly indicates that monetary policy is generally not the right tool to counter price increases due to supply disruptions.

However, one thing that some central bankers seem to have misinterpreted is how consumer demand has remained strong and added to inflationary pressures, especially in economies like the United States. The huge amounts of central bank money creation and government spending in the years following the 2008-2009 global financial crisis, both of which increased further to cope with the COVID-related recession, also created latent inflationary pressures. These pressures remained latent until the combination of strong demand and weak supply finally triggered the recent surge in inflation.

The risk for central bankers is that they lose control of the inflation discourse if expectations about future inflation turn out to be true. Rising inflation expectations can become a self-fulfilling prophecy, as workers demand higher wages and companies raise prices in parallel, making it very difficult to control inflation.

Why should rising prices bother us if incomes will also rise along with prices? What exactly are the economic costs of high inflation that force central banks to raise interest rates?

High inflation is often accompanied by rising wages as workers try to protect the purchasing power of their earnings. The effects of high inflation generally hit the poor the hardest, who may not have stable incomes or formal sector jobs with which to make wage gains that match inflation. Expenditure on food and energy constitutes a large share of the consumption baskets of the poorest households, so high inflation of food and energy is particularly difficult for them. Moreover, they would not benefit from the increase in the face value of financial assets simply because they tend to have few such assets to begin with.

High inflation also tends to be more volatile; in turn, this volatility and uncertainty can dampen business investment, with negative effects on employment and output growth. High inflation also erodes confidence in the government and central bank, which can create upward momentum in inflation that can spin out of control and cause further economic disruption.

Why has the US dollar strengthened over the past decade and a half despite the accommodative monetary policy adopted by the US Federal Reserve since the 2008 financial crisis? Is this a sign that other central banks have adopted much worse monetary policies?

The strength of the dollar is symptomatic and also contributing to the economic and financial distress in the world. The continued rise in the dollar reflects a combination of stronger economic fundamentals and stronger inflationary pressures in the United States than in most other major economies, which together point to further interest rate hikes by the Fed.

A stronger dollar will help moderate inflationary pressures in the United States somewhat, although it is far from sufficient to overcome the supply-side constraints and the strength of demand that are fueling these pressures. On the other hand, a strong dollar makes a bad situation worse in the rest of the world. Fed rate hikes and the strong dollar have tightened financing conditions in global markets and increased the debt service burden of developing countries whose governments and businesses have borrowed heavily in dollars.

Many currencies that have depreciated against the dollar have actually not changed much in value against other currencies on a trade-weighted basis. [The Indian rupee is an example—down by about 10-12 percent relative to the dollar over this year but the trade-weighted nominal exchange rate of the rupee is down only by about 2-3 percent]. Nevertheless, the depreciation against the dollar adds to inflationary pressures in many economies since most of their imports are denominated in dollars.

A strong dollar aggravates the already difficult circumstances in which many countries find themselves and could lead to even more problems for countries that have little macroeconomic space to deal with rising inflation and falling growth. .

For a long time, the inflation rate in developing countries like India was higher than the inflation rate in developed economies like the United States. But today, inflation rates in developed countries are as high as those in developing countries. Do you see this as a temporary or more permanent (secular) change in global inflation trends?

The risk is that high inflation takes root in advanced economies, which could influence the behavior of workers and businesses and, in turn, make it more difficult to control inflation and bring it down to reasonable levels.

Many advanced economies are now facing a combination of steep currency depreciations (against the US dollar), rising government bond yields, strains on public finances and tightening political constraints that have long characterized periods economic and financial stress in emerging market economies.

My impression is that the major central banks of advanced economies have all committed to bringing inflation down to moderate levels, in line with their respective inflation targets. To that end, they seem willing to tolerate lower GDP growth, higher unemployment, and possibly even recessions. All of these are painful consequences of tighter monetary policy, but the consensus seems to be that any delay in bringing inflation under control could cause even more pain and economic turmoil in the future.

Are central banks increasingly used today to finance public spending? If so, what are the implications of the compromise on central bank independence?

The Great Recession of 2008-2009, which mainly hit advanced economies but whose repercussions were felt around the world, was met with a sufficiently aggressive response from national governments in the form of massive increases in spending financed by debt to avoid economic collapse. This pattern repeated itself amid the global COVID-related recession, albeit short-lived.

During the prolonged period of near-zero policy interest rates in advanced economies, central banks started printing money and buying up a lot of that government debt. They did this in an attempt to stimulate consumption and investment by keeping long-term interest rates low.

Pressure on central banks to finance government deficits has been a long-standing problem for central banks in emerging market economies, but with their actions in recent years, central banks in advanced economies have also set an unfortunate precedent. similar. This poses a threat to the autonomy of central banks, although their institutional independence is likely to allow central banks in advanced economies to fend off political pressure to continue financing the accumulation of public debt.

is there an exit?

Governments and central banks no longer have the luxury of unfettered fiscal and monetary stimulus to stabilize growth and offset negative shocks. At a minimum, governments should avoid unnecessary populist policies (especially ill-targeted fiscal measures), do what they can to overcome supply bottlenecks, and support central banks in their efforts to rein in inflation. inflation.

Faced with limited room for manoeuvre, monetary, fiscal and other economic policies must act in concert to mitigate inflationary pressures in the short term and focus on measures likely to improve long-term growth. Easing constraints on labor supply and trade, for example, in addition to providing incentives for investments in green technologies and various forms of infrastructure, could help. Such measures are in turn essential to support both private sector demand and near-term confidence while helping to reanchor inflation expectations.