IMF warns that higher inflation is here for longer

“When governments lack fiscal space or political support to respond to the problem, central banks may need to adjust their monetary policy reaction function to account for financial stress.”

But she added there should be a “high bar” before leading central banks accept inflation staying above their 2 per cent target for longer because it could make price growth even more entrenched, as happened in the US in the 1960s.

Financial stress in the eurozone “may also have diverse regional effects, with [interest rate] spreads rising more 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.

Ms Gopinath said in her speech that the ECB and other central banks “should be prepared to react forcefully” to signs of persistent inflation even if it leads to “much more cooling” in labour markets.

The ECB has raised its benchmark deposit rate at an unprecedented pace from minus 0.5 per cent last year to 3.5 per cent earlier this month, and signalled another quarter-point rise is “very likely” in July.

Governments could also help fight inflation by reducing deficit-funded spending to cut demand and lower the amount by which the ECB needs to raise rates, she said.

“Given the economic conditions we have, both because of high inflation and record high debt levels, the two would call for a tightening of fiscal policy,” she said. “If you look at projected fiscal deficits for many G7 countries, they look too high for too long.”

The ECB has created a bond-buying program, called the transmission protection instrument, designed to avoid rising borrowing costs triggering another eurozone sovereign debt crisis. But this is untested and Ms Gopinath said more could be done to prepare for potential financial stress.

She called on EU governments to agree to new rules for reducing their budget deficits and debt levels, which have risen above 100 per cent of gross domestic product in many countries including France and Italy, and to create a single deposit insurance scheme for all eurozone banks to replace the current patchwork of national systems.

The US government provided additional deposit guarantees to ease the crisis in US banking sparked by the collapse of Silicon Valley Bank in March.

“You could have an episode of that kind, or something more severe than that, where it is politically not feasible to get that kind of fiscal support,” Ms Gopinath told the FT. “Or you are dealing with non-banks, in which case it becomes very politically difficult.”

Financial Times