Uphill struggle

The Russia-Ukraine crisis has massively complicated the task facing central banks trying to battle inflation, especially the Federal Reserve of the United States. What was already an extremely difficult challenge and balancing task has been ratcheted up with additional levels of complexity.

Over my decades of experience of living through economic crises and periods of high anxiety, central banks usually have the trickiest of challenges during these crises and none of them are ever, exactly similar. But there are significant aspects of the current situation that do bear resemblance to the 1970s and the era of oil price crises.

Quite understandably the 1970s was characterized as the era of "stagflation" as the world was beset by persistent inflationary pressures and with it, very weak growth, and often reoccurring recessions, or near recessions. The fallout from this period is arguably what led to the US embracing monetarism and the philosophy of Milton Friedman in terms of monetary policy, which went on to dominate the 1980s and the era until the early 1990s when it was supplanted by inflation targeting.

Throughout this period, central bankers learned, or at least thought they learned, how to deal with two different situations, namely that in which an external price shock, such as an oil price shock, adds impetus to the inflation mechanism, or that in which it is a source of price increases that is the prime transmission mechanism which deflates the real incomes of consumers. Both of the situations are negative for economic growth.

Each requires a different monetary policy response.

What further complicates the decision-making process for central banks is the interplay with financial markets. In traditional monetarism and even today, there is the belief that the lag between a central bank's monetary policy change and the inflation outcome is 18 to 24 months. In this context, in isolation, most central banks, including the Federal Reserve Board, would probably conclude the huge price increase in energy－as well as other commodities, is not a demand shock, but a supply shock, and probably temporary, but they will have the effect of depressing economic activity through lowering real incomes. In this light, the Fed might "look through" events and either soften its planned monetary tightening or even pause.

The dilemma for the Fed is, of course, they had concluded that COVID-19 influences on the price mechanism initially were also temporary and only changed their mind in late 2021, and had, until two weeks ago, presented a view that they were now much more concerned about the inflation outlook. The very latest US employment report, all else being equal, would have, added to this view.

However, one other crucial issue is the interplay with financial conditions. During my early time at Goldman Sachs, I helped preside over the development of financial conditions indices, which then, consisted of a combination of short-term interest rates, long term bond yields, exchange rates and equity indices. Collectively, we found strong evidence that big changes in financial conditions were rather good leading indicators of the US economy. They also seemed quite useful globally and elsewhere, especially adjusted for oil prices.

Because of the weak performance of financial markets in January, even before this latest crisis, financial conditions have already tightened notably, and now, they have tightened considerably. Advocates of such leading indicators would therefore want to be more careful about adding to further tightening of financial conditions by unexpectedly raising interest rates. In this context, I think it is unlikely that the Fed will raise rates sharply at its next opportunity, and it will undertake only what is priced in the markets, and wait to see how the global situation evolves.

If all of this wasn't tricky enough, there are two other huge dilemmas that will influence it going forward.

One is obviously the perceived length and scale of the Ukraine conflict. If for some reason, it were to extend especially beyond the borders of Ukraine, it would probably add to the decision to "look through" but this has to be borne against the second.

This one relates to the consequences of the G7 nations' decision to freeze the assets that Russia's central bank holds with Western central banks. If this forceful move leads to a number of big emerging country central banks choosing to abandon their implicit desire to build bigger foreign exchange reserves, then this would impact the popular economic judgement of many years about the so-called savings glut. That is, it would diminish it, and remove the idea of this influence on the supposed secular decline in global real interest rates, especially for the US, as presumably, this would reduce the net external demand for US safe assets. All of this would suggest a steeper path for short rates in the US going forward.

The author is former chief economist at Goldman Sachs. The author contributed this article to China Watch, a think tank powered by China Daily. The views do not necessarily reflect those of China Daily.

Contact the editor at editor@chinawatch.cn