The world’s central bankers are in a quandary over the Iranian war and the inflationary pressure it generates. They must be reflecting that, having gone through a big inflationary period in 2022-23, inflation expectations are not well anchored. Central banks’ best policy would be to try to anchor those expectations and give no solace to those who feel that more inflation is coming.
But two very important problems could lead them to opt for a different and more inflationary solution.
Problems of financial and fiscal dominance
We’ve had 20 to 30 years of excessively easy monetary policy and fiscal policy. The upshot is a problem of both financial dominance and fiscal dominance.
The financial dominance problem arises from the fact that there has been a massive increase in private sector debt and leveraging – not only just more debt but lower-quality debt – and credit being increasingly provided by people outside the regulated financial system. Tighter money in current circumstances raises the prospect of financial instability and deflation, or much slower growth that nobody is going to be prepared to accept.
Associated with this, fiscal dominance is becoming increasingly worrying. In the last year or two, the interest payments on government debt in some countries have become so short term and massive that an increase in interest rates could lead to expectations that debt service will increasingly have to be provided through governments going to their central banks. Fears of debt monetisation will not be helped by the fact that central banks expanded their balance sheets during the Covid-19 pandemic almost as much as governments expanded their debts.
Short-term interest rates have fallen since the end of Covid-19, but long rates have actually gone up. This is very unusual. The worry is that central bankers will decide that fighting low growth is more important than fighting inflation, particularly since raising interest rates to fight inflation might actually have the opposite effect from the one they anticipate.
Gulf war compounds the issues
All these problems could become acute because the Iranian war brings long-lasting repercussions. President Donald Trump will not realise his dream of quick regime change in Iran. The war will continue as long as all the parties that are participating decide it should go on. The Americans want the war to end quickly because of all the global economic damage that’s being done. But the Iranian strategy is to keep the conflict going and to be widely dispersed in its effects. This war is going to go on for quite a long time.
The Gulf war adds another big negative supply shock against the difficult backdrop of these growing financial and fiscal imbalances. It implies that inflation could be much higher than currently expected. Arguably worse are secular forces that imply stagflation will be inherent in the system in coming years. We’ve gone from an era of plenty and are now entering an era of scarcity.
We had 20 years of positive supply shocks. Demographics were favourable. No one worried too much about climate change. Globalisation was disinflationary. Firms were looking for efficiency in production and global supply chains. All these positive shocks are now turning negative.
In addition to the supply side, the demand side is turning around too. We had 20 or 30 years of the peace dividend. That’s now going in the opposite direction. On the investment side, we didn’t have to invest in the big advanced-market economies because we were investing in China and the emerging markets. That’s gone into reverse as well. We need domestic investment for security purposes and on a large scale to deal with climate change. The underlying force is towards secular stagnation.
We’ve seen already in the US, the UK and Europe a shortening of the duration of government debt issued. That has the merit of keeping long-term rates lower than they would otherwise be, but it also makes the government more exposed to higher rates increasing debt service costs.
Central banks cannot solve the dilemma alone
There are some real problems looming that do not yet seem to have been fully appreciated, particularly prospective fiscal dominance. The markets are not panicking. Long rates have gone up, but not by a lot.
Ultimately, it’s a psychological issue. Up to a certain point, people continue to say, ‘Higher rates will do the job of getting inflation down.’ But beyond that point, they say: ‘Well, no, they won’t actually. It’ll lead to more recourse to the central bank and eventually more inflation.’
In that latter situation, even ‘independent’ central banks will face a dilemma that they alone cannot resolve. Absent a significant degree of fiscal consolidation, the outcome is likely to be significantly higher inflation.
Willliam White is a Senior Fellow at the CD Howe Institute and a Member of OMFIF’s Advisory Council. He was Head of the Monetary and Economic Department at the Bank for International Settlements from 1995-2008. This article is based on his remarks at an OMFIF roundtable discussion on the Iranian war on 16 March.
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