The International Monetary Fund warns central banks of the “inconvenient truth” in fighting inflation

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The vice-president of the International Monetary Fund has warned that central banks must accept the “uncomfortable fact” that they may have to endure a longer period of inflation above their 2 per cent target to avoid a financial crisis.

Speaking at the European Central Bank’s annual conference in Sintra, Portugal, Gita Gopinath said policymakers risked facing a stark choice between resolving a future financial meltdown among highly indebted countries and increasing borrowing costs enough to tame stubborn inflation.

“We’re not there yet, but it’s a possibility,” Gopinath told the Financial Times ahead of her speech. “In this environment, you can see central banks adjusting their reaction function and saying ‘OK, maybe we’ll tolerate higher inflation for a while’.”

Gopinath, who was promoted last year from chief economist at the International Monetary Fund to deputy managing director, said many European governments’ high debt levels leave them vulnerable to another financial crisis.

“We are entering a period where we have to realize that inflation takes a long time to reach the target – and this is the first uncomfortable fact – and that means we risk inflation becoming entrenched,” Gopinath said.

“When governments lack the fiscal space or political support to respond to a problem, central banks may need to adjust their monetary policy response function to account for fiscal pressures,” she said in her speech.

But, she added, there must be a “high bound” before major central banks will accept that inflation remains above the 2 percent target for a longer period because it could make price growth more entrenched, as happened in the United States in the 1960s.

Fiscal stresses in the euro area may also have various regional effects [interest rate] Increase profit margins in some high-debt economies,” and this could “amplify other vulnerabilities arising from household indebtedness and a large share of variable-rate mortgages in some countries,” she said.

In her speech, Gopinath said that the ECB and other central banks “should be prepared to respond aggressively” to signs of persistent inflation even if it leads to “more calm” in the labor markets.

The European Central Bank has already raised its benchmark deposit rate at an unprecedented pace from negative 0.5 per cent last year to 3.5 per cent earlier this month, and has indicated that another quarter-point rise is “very likely” in July.

She said governments could also help fight inflation by reducing deficit-financed spending to lower demand and lower the amount the European Central Bank needs to raise interest rates.

She said, “Given the economic conditions we are living through, due to high inflation and record high debt levels, the two will call for tightening fiscal policy.” “If you look at the projected fiscal deficits of many of the G7 countries, they look very high for a very long time.”

The European Central Bank created a bond-buying program, called the Conversion Protection Instrument, which is designed to avoid rising borrowing costs leading to another eurozone sovereign debt crisis. But this has not been tested and Gopinath said more could be done to prepare for potential financial pressures.

It called on EU governments to agree new rules to reduce their budget deficits and debt levels, which have risen to more than 100 percent of GDP in several countries including France and Italy, and to create a single deposit insurance scheme for all eurozone banks. To replace the current patching of national systems.

The US government provided additional deposit guarantees to ease the crisis in US banks triggered by the Silicon Valley collapse in March.

“You could have a bout of this kind, or something more serious than that, where it is not politically feasible to get this kind of financial support,” Gopinath told the Financial Times. “Or you’re dealing with non-banks, in which case it becomes very difficult politically.”