Warning from the Central Banks’ Bank: Brace Yourself for an Impending Reality Check in the Global Economy

**Risks and Challenges Facing the Global Economy**

The global economy is currently facing a critical juncture characterized by a combination of high inflation and financial fault lines. These challenges have the potential to impact prosperity for years to come. In order to prevent these problems from becoming entrenched, it is important to assess and understand the limitations of current policy settings.

**High Inflation and its Potential Persistence**

Although global inflation has decreased from its peak levels due to normalized supply chains, falling commodity prices, and monetary policy tightening by central banks, there is a risk that high inflation could persist. New price pressures may emerge, leading to a decrease in households’ purchasing power as wages fail to keep pace with inflation. This imbalance may prompt workers to seek higher wages, leading to a vicious cycle of rising prices. Consequently, it can be difficult to halt this trend once it takes hold.

**Financial Stability Risks**

Furthermore, financial stability risks loom large. Debt and asset prices currently exceed levels seen in previous periods of interest rate hikes. While pandemic-era savings and longer loan terms have provided some buffers, these reserves are gradually depleting. As a result, economic growth could slow more than expected. These financial strains are likely to manifest as credit losses, posing a risk to weakened banks. In the past, banking stress has often coincided with higher interest rates. The combination of high debt, high asset prices, and high inflation intensifies these risks. Despite the relative strength of banks compared to previous crises, there are still pockets of vulnerability, particularly among smaller banks that were not subject to regulations aimed at strengthening the sector. Recent experiences have shown that even smaller institutions can trigger systemic collapses in confidence. Non-bank financial institutions, which have grown substantially since the Great Financial Crisis, will also face challenges. These investment firms are often burdened with hidden leverage and liquidity mismatches, and their business models may be tested in a prolonged period of higher interest rates.

**Government Finances and Their Impact on Financial Stability**

The fragility of government finances further complicates the current economic landscape. Severe financial instability may necessitate government intervention to stabilize markets, but this would come at the cost of reduced fiscal revenues due to impaired growth. Consequently, this would exacerbate already high levels of public debt and create doubts about a government’s ability to meet its financial obligations, thereby adding to financial instability.

**Policy Responses and Priorities**

To address these challenges, policymakers need to take decisive action. Central banks must prioritize the restoration of price stability, as prolonged high inflation would have significant costs, particularly for the most vulnerable segments of society. In addition, measures must be implemented to ensure the safety and stability of financial institutions and the overall financial system. Where gaps exist, new regulations may be necessary to fill these voids. Collaboration between central banks and governments is crucial in keeping macroprudential policies tight, limiting the strains on banks caused by higher interest rates. Strengthened bank supervision can also help rectify the issues uncovered in recent bank failures. Policymakers are urged to implement Basel III without delay.

Furthermore, fiscal policy must be consolidated as it can contribute to the fight against inflation and promote financial resilience. By consolidating fiscal policy, governments can create buffers that can be utilized during future economic downturns.

**A Long-Term View and Structural Reforms**

Above all, policymakers should adopt a long-term perspective. Monetary and fiscal policies have borne the brunt of sustaining economic growth, resulting in the overextension of their capacities and pushing the boundaries of what is considered stable. This has led to historical instances of high inflation, economic slumps, and crises in areas such as banking, currency, and sovereign debt.

To drive long-term economic prosperity, policymakers need to recognize the limitations of repeated emergency action and focus on implementing long-neglected structural reforms. This shift in mindset is necessary to avoid eroding the trust that society places in the decision-making process. Price and financial stability are key in securing broader economic prosperity over the long term.

**About the Author**

Agustín Carstens is the general manager of the Bank for International Settlements (BIS).


The opinions expressed in this article are solely those of the author and do not necessarily reflect the views and beliefs of Fortune.

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