Slaying elevated inflation and combating a financial crisis – that’s the challenge keeping the US Federal Reserve and other central bankers on their toes.
Both these issues are not new. But what happens when they need to be addressed at the same time? Is there a playbook that central banks can turn to?
Former Federal Reserve Chair Paul Volcker slayed inflation, and Ben Bernanke saved the banks, but can current Chief Jerome Powell do both?
Well, that is the need of the hour.
The current banking crisis threatens financial stability, while inflation threatens to push ahead. And that is not restricted to the confines of the US but risks spreading beyond its borders.
At first glance, the Fed under Powell’s leadership and other major central banks continued this week with the same policy they have had in place for the past year, which is to raise interest rates to bring down inflation.
In reality, however, everything is different now that a series of bank failures has sent tremors through global financial markets. Threats to financial stability were not even on the radar of central bankers until recently.
To hear Powell and his colleagues tell it, avoiding another round of inflation like the one experienced in the 1970s is still job one.
But the signal is shifting that is warranting a policy similar to what Ben Bernanke used during and after the global financial crisis. Bernanke fought off the 2008 crisis by adopting unprecedented methods, including doling out free cash to banks.
After Silicon Valley Bank failed and Credit Suisse was taken over by a shotgun marriage, the Fed only raised interest rates by half as much as was anticipated. The European Central Bank and the Swiss National Bank hiked as expected, but they refrained from providing any forward guidance.
The recent wild swings in market bets on policy show that investors, too, are having a hard time figuring this out. After SVB’s failure, they shifted from pricing in an aggressive Fed that hikes several more times to pricing in a “we’re all doomed” scenario of imminent rate cuts.
Analysts say the core dilemma for policymakers is that prescriptions for controlling prices and boosting banks point in opposite directions.
According to Ethan Harris, Head of Global Economics Research at Bank of America, “the market is acting as if we’re in the midst of a pretty serious crisis.”
“It’s putting a very high weight on an adverse scenario where you have a big financial event and a very bad economy,” added BofA’s Harris, who was the former head of research at Lehman Brothers before its collapse in 2008.
To get inflation down, central banks jack up rates. They give money to struggling lenders and lower the cost of borrowing to avert crises. And the danger is that they end up with the worst of both worlds: a full-blown crisis that triggers a recession.
Then central banks would be forced to abandon the fight against inflation before it was over.
Anna Wong, Chief US economist at Bloomberg, drawing on a study of American banking crises over the last 140 years, said, “the tension between fighting inflation versus preserving financial stability is now more stark than any time in the Fed’s history.”
The current crisis would have to take a significant turn for the worse,” she says referring that tighter credit would take a decent-sized bite out of inflation.
And if that doesn’t happen, “markets will have to revise up their estimates for the Fed’s policy path.”
So, what remains to be seen is, have the predictions now turned for the worse, or the better? A softer tone or an aggressive one will define the path the world’s largest economy takes.
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