Monetary policy in the time of a pandemic: the new challenge for the emerging economies

Manuel Aguilera

General manager of MAPFRE Economics

An old friend of economists —who had been lurking around for some time— has become the main protagonist of the post-pandemic economic recovery: inflation. In recent months, the global economy has been characterized by upward pressure on prices that is more or less widespread, placing inflation above the target of central banks in many cases. So far, the prevailing view is that these inflationary pressures are essentially transitory and explained by a rise in raw material and energy prices, along with temporary supply disruptions caused by restrictions to prevent the spread of COVID-19. However, there are indications that inflation, as was the case the last time it was on the front lines of an economic crisis, is attempting to have its way again. 

As the global economy moves out of the pandemic, the factors that explain rising inflation as a purely transitional condition (especially those linked to a temporary supply shock amid resurging demand) appear to be weakening, and the hypothesis of more structural inflation is starting to gain ground as an economic interpretation. An indication of this can be found in the communications of the central banks in the main developed countries, which suggest the start of not only a gradual reduction in liquidity support, but also a possible normalization of monetary policy through increased interest rates, which could start at the end of next year. 

In this context, monetary policy faces the challenge of responding to, on the one hand, the correct theoretical interpretation of the nature (temporal or structural) of the pressures on prices, and on the other, the logic and the policy space for adopting orthodox measures to combat inflation at the expense of hindering economic revival. In the developed markets, the solution to this dilemma seems to have shifted towards interpreting a restrictive monetary policy as essential to prevent temporary inflationary pressures from becoming structural in nature. However, leveraging the particularities of the price formation process, the central banks in these economies have considered prolonging the expansionary measures as much as possible, to avoid curbing economic recovery, and then implementing monetary normalization that limits the structural strengthening of inflation. 

In the emerging markets, however, the situation is more complex. While in the developed countries, the price formation process has been strongly conditioned by structural factors (such as the greater marginal propensity to save due to population aging) for a long time, helping to contain inflation expectations and keep interest rates extremely low, this process has other nuances in the emerging countries. In the developing world, on the one hand, inflationary pressures are becoming more acute, due largely to increased supply side rigidities and the transmission of price pressures through imports of tradable goods and inputs for production. On the other hand, inflation and its expectations have managed to fall within the central banks’ target for only short periods, so maintaining an expansionary policy amid rebounding prices is a difficult monetary policy to maintain. 

In general, the central banks of the main emerging markets have started to respond by raising interest rates. However, while some central banks (such as those of Egypt, India, the Philippines, Indonesia and South Africa) have decided to keep their monetary stance virtually unchanged for the time being, others —such as Argentina (with annual inflation above 48%) or Turkey (close to 20%)— have even reduced their interest rates. This has been driven perhaps by the rationale of not limiting economic recovery by attempting to address transient pressures that could be dissolved in the coming months, or perhaps only by local policy considerations. In these cases, by maintaining a heterodox monetary policy, they run the risk of soon facing a situation that confirms that price pressures have ceased to be transitory, meaning that in the near future, they will have to address inflation that could, at best, easily get out of control, and at worst, recreate a hyperinflation scenario. 

But the emerging markets that have decided to take an orthodox approach to inflationary pressures are not out of the woods yet. The increase in interest rates they have started, which will inevitably impact the speed of economic recovery, will soon square off with the start of the monetary normalization process in advanced countries. Consequently, their domestic monetary policy will have to keep pace with the rise in interest rates in the developed world to avoid further impacts on their exchange rates and, through the pass-through mechanism, on the price level in the economy as well. 

It is clear that monetary policy in the emerging countries must aim to conduct an orderly price adjustment process, avoiding an impact on inflation expectations and, at the same time, ensuring that economic recovery is not harmed — with or without an explicit mandate to do so. In this regard, it seems inevitable that they will converge on a more restrictive monetary policy that, in the coming months, will also have to keep pace with monetary normalization in the developed countries. The primary goal will be to keep inflation at bay and mitigate its potential impact on expectations, but without ignoring the effects on economic activity and the depreciation of their currencies. 

Tinbergen's principle highlights the conflict between the objectives of economic policy and the instruments available to those who design and implement it; in short, that in order to achieve a certain number of objectives, an equal number of instruments must be available. It is clear that monetary policy in the emerging countries is unlikely to contain, in itself, the answer to the set of objectives for the immediate future, so it will have to be supported by other economic policy instruments. Therefore, there are difficult days ahead for the central banks in the emerging world. As the Austrian economist Ludwig von Mises once wrote: “No very deep knowledge of economics is needed to grasp the immediate effects of a measure; but the task of economics is to foretell the remoter effects, and so to allow us to avoid such acts as the attempt to remedy a present ill by sowing the seeds of a much greater ill for the future.” This continues to be the challenge.