Recently, Gita Gopinath, the deputy managing director of the IMF, delivered a speech at the European Central Bank forum where she issued a warning. Gopinath emphasized that central banks may find it impossible to raise interest rates sufficiently to effectively combat inflation. She outlined three troubling truths about the current state of inflation that have caught central bankers off guard, despite their role in understanding such matters.
The first surprise is the persistence of entrenched inflation, despite the most aggressive global interest rate hikes witnessed in the past 50 years. This is noteworthy because previous measures to tackle inflation, such as addressing commodities and energy prices during recessions, have yielded limited results. Core inflation, the type that concerns central banks the most, has shown no improvement for at least the past six months.
The second unexpected revelation is the vulnerability of commercial banks. In fact, the number of failed banks in the United States has already surpassed the count during the 2008 financial crisis, and this is before the worst of the recession has even hit. Gopinath cautions that as interest rate hits burden banks and borrower defaults rise during an economic downturn, government bailouts may need to be expanded. Paradoxically, these bailouts themselves could generate additional inflationary pressures.
These surprises collectively suggest that central bankers are facing a predicament. Conventional interest rate hikes may not be sufficient to curb inflation, as raising rates significantly enough to constrain the real economy could lead to either the collapse of the entire banking system or the need to print even more money than what was done during the COVID lockdowns.
The third surprise, and perhaps the most foreboding, is the presence of structural changes impacting aggregate supply. These changes have the potential to trigger larger and more enduring shocks. In simpler terms, major economies around the world have become chronically weaker. This should come as no surprise, considering the burden of soaring regulations that stifle producers—whether justified by COVID, climate concerns, or social justice. Additionally, government stimulus and industrial policies redirect resources away from productive businesses while funding competitors who can afford to sustain losses, thanks to taxpayer money. These factors collectively undermine small businesses and entrepreneurs who are the driving force behind economic growth.
If these structural changes persist, it implies a prolonged period of inflation. In fact, if governments continue to suppress the economy while aggressively printing money, as they have done in recent years, we may experience a significant deterioration in growth, income, and inflation. The solution, frustratingly simple yet unlikely to be embraced, involves reducing the size of the government, slashing regulations, mandates, and taxes that burden producers, and cutting government spending that fuels inflation, ultimately leading central banks to strangle the real economy through rate hikes.
Though the IMF and central bankers are unlikely to acknowledge this reality, downsizing the government significantly is the only viable path out of this predicament. We are rapidly approaching a critical juncture where downsizing the government & Cutting spending drastically is the only option to salvage the situation.
Until next time, stay informed and stay vigilant.