Central banks must switch to a war footing

Financial markets haven't grasped fundamental shift

The world has changed over the past two weeks and central banks’ policy cannot stay the same, especially in Europe.

War brings a policy conundrum for global leaders, with potentially diverse geopolitical and economic outcomes. Once the genie of military action is out of the bottle, it is hugely challenging to put it back. Even the best possible development in the Ukrainian conflict would be an armed truce, not true peace. It would involve an immediate ceasefire, perhaps with some territorial concessions to Russia and a neutral Ukraine before a gradual de-escalation. It would allow some normalisation only over time.

However, it would not be business as usual for central banks. Sanctions and disruptions to the global supply chain are here to stay. Central banks will lack clarity on the effects of these economic phenomena. The risk of a long-lasting impact on supply with a persistent adverse consequence on economic growth cannot be easily dismissed.

What can central banks do? For a start, they should hold fire on policy decisions until the situation has somewhat clarified, but this would probably not be enough. They would also need to increase flexibility and optionality in their toolbox for any future policy response.

The European Central Bank is still determined to exit from net asset purchases whenever possible. Increasing flexibility and leaving open policy options would mean introducing a scheme like the pandemic emergency purchase programme, to allow the central bank to intervene with asset purchases without constraints. It would aim to avoid any fragmentation and provide policy support.

It makes sense to eliminate any forward guidance to avoid damage to credibility in such an uncertain policy environment. Instead, the ECB would simply commit to doing whatever is necessary to maintain price stability and favourable financing conditions.

Maintaining stability in financial markets would include a clear commitment to stand ready to inject as much liquidity as necessary to counteract market volatility and instability, especially to support financial intermediaries that might experience liquidity troubles. It could take the form of more generous targeted longer-term refinancing operations and a recalibration of the ECB’s two-tier system for reserve remuneration.

Central banks in Europe should stay calm and keep assessing the situation amid a probable inflation spike. The rise in energy and food prices is mainly related to supply constraints that central banks cannot address. They cannot open up Russian gas pipelines. They cannot restore the smooth supply of grain and wheat from Ukraine. They cannot find the many rare earths, minerals and gas that are to likely run short in international markets. They can only try to support confidence and make sure that the financial plumbing facilitates the smooth functioning of the economy. Trying to get a hold on short-term inflation would be useless and counterproductive. They should rather keep focusing on the medium-term outlook.

It is puzzling how financial markets reacted to war developments. On 3 February, five-year inflation swaps projected a rate of 2.1%. Then, inflation expectations started to de-anchor moderately from the ECB’s inflation target. Following the Russian invasion of Ukraine on 24 February, inflation expectations jumped and became even more de-anchored, reaching 3%, amid a rise in inflation to 5.8% in February. For the first time, 5y-5y breakeven inflation moved above 2%. The more protracted the spikes in inflation and inflation expectations, the higher the risk of second-round effects. However, in wartime, the negative impact on the economy is far more significant and policy-relevant than any spike in inflation related to supply-side and war-related sanctions or initiatives. Financial markets do not appear to have yet grasped this fundamental shift.

Unconventional policies can still provide some extra accommodation. However, central banks are too close to the effective lower bound to provide material support. No matter how creative they may become in the future, most of the heavy lifting would have to come again from the fiscal side. The sooner, the better.

Lorenzo Codogno is Visiting Professor at the London School of Economics and Founder and Chief Economist of LC Macro Advisors.

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