In many countries, the political landscape is changing dramatically, possibly foreshadowing more radical policies in both the United States and Europe. Faced with an aging population, deglobalization, climate change, anti-immigrant sentiment, and technological advances, central banks will feel pressure from many different fronts in the coming years.
One obvious concern is fiscal policy and debt. When radical politicians come to power, they rarely have austerity in mind. Most arrive with bold, sweeping plans that require massive increases in spending. (Argentine President Javier Milei is an exception, in part because he was elected to reverse the policies of the radicals who governed before him.)
But moderate leaders will also feel increased pressure to spend in the coming years. Real (inflation-adjusted) interest rates are likely to return to their long-term trend, meaning that debt service costs will eat up a larger percentage of government budgets. Military spending will undoubtedly increase, given the current geopolitical landscape, and education spending will likely have to rise as governments attempt to prepare their populations for an age of artificial intelligence. On top of all this, climate change-related spending and subsidies have become more urgent. Political dysfunction makes it difficult to tax emissions, which would be more fiscally prudent, or to increase tax revenues more generally.
All this additional net spending means that central banks will have to offset governments’ expansionary impulses with tighter policy. But with many countries already heavily indebted, higher and sustained real policy rates will fuel doubts about debt sustainability. Will central banks cave and allow more price growth, hoping to deflate some of the debt? Or will they stand firm against their respective governments, raise rates, and risk a Liz Truss moment? When fiscal priorities and debt levels determine the scope of monetary policy, economists speak of “fiscal dominance.” This will likely happen more frequently in the future.
What about demographic trends?
Charles Goodhart and Manoj Pradhan believe that, with China’s shrinking working-age population and aging populations elsewhere, growth will slow given the shrinking labor force. Meanwhile, spending will increase—in part to meet the need for greater care for the elderly—and wage growth may strengthen in the face of labor shortages. All of this will likely be inflationary.
Of course, others believe that savings will increase with aging and that immigration to aging countries will help avoid labor shortages. But given the outright reluctance of many aging countries to accept large numbers of immigrants, this optimistic scenario seems less likely.
Since Donald Trump imposed massive tariffs on imports from China, we have witnessed a widespread return to protectionism, which has resulted, first and foremost, in less cross-border investment. So far, trade has helped, in part because Chinese inputs are being shipped to other countries for final assembly before arriving in the United States. But if Trump returns to the White House in January, he will try to end this type of transshipment, while simultaneously increasing tariffs across the board.
Deglobalization will continue to drive up the price of foreign goods. But whether or not this process is inflationary may depend on how it unfolds. As Ludovica Ambrosino, Jenny Chan, and Silvana Tenreyro observe in a forthcoming paper, if tariffs are imposed suddenly, inflation will spike significantly, and central banks will find it difficult to avoid raising interest rates.
Researchers suggest that, in the medium term, domestic importers will turn to alternative suppliers, and as the economy becomes poorer and consumption lower (each dollar spent will buy fewer imports), inflation will decline. Interestingly, if higher import prices take effect gradually, a drop in demand in anticipation of higher import prices could lead to a slowdown in inflation for domestic goods, thus keeping overall inflation contained. Consequently, protectionism may raise import prices, but since it also makes us poorer and depresses demand, inflation may not
too much.
Now, we must contextualize this relatively benign view against our experience in the decades of globalization preceding the global financial crisis, when inflation fell worldwide. If globalization lowered inflation, shouldn’t deglobalization raise it?
This is the argument of Hassan Afrouzi, Marina Halac, Kenneth Rogoff, and Pierre Yared. Deglobalization, by reducing competition, will boost monopoly profits and thus increase the temptation for central banks to allow higher inflation (as a way to erode those profits and sustain workers’ share of production). Of course, deglobalization could also increase union power, which, under the same assumptions, should mitigate this temptation. But given that globalization was accompanied by lower inflation, we should at least be prepared for the possibility that deglobalization will do the exact opposite.
The transition to a low-carbon economy will further complicate the picture. As suggested by ongoing work by Luca Fornaro, Veronica Guerrieri, and Lucrezia Reichlin, green regulations often impose additional costs on dirty energy sources, sometimes to the point that banks won’t even finance such projects. But as long as dirty energy remains a necessary input for production, production that relies on it will be more expensive. And when demand increases, companies will have to use more dirty energy, driving up production costs and prices even further.
To contain inflation, central bank policies will have to be much tighter, and that will mean slower growth. This may also slow the shift in demand toward green energy and inhibit investment in renewables (which, in the medium term, would alleviate dependence on fossil fuels). Given this outlook, green-minded central banks will reasonably want to be more tolerant of higher inflation to facilitate the green transition.
Most of the forces and dynamics discussed here exert upward pressure on inflation. It is true that if productivity increases as a result of technological advances such as the widespread implementation of AI, inflationary pressures could moderate due to a larger and cheaper supply. At this point, however, there is more hope than reality.
Perhaps the biggest concern is that, with electorates demanding change, radical leaders might create the conditions for higher inflation—for example, by curbing immigration or spending without restraint, even if this erodes the independence of the central bank. This has happened regularly in the past, and the consequences were not pleasant. Perhaps we need to relearn past lessons the hard way.
