Central Bankers Must Keep Financial Stability in Mind as They Fight Inflation

An Opinion Piece by a Journalist

The ongoing banking crises in the United States and Europe have made the job of central banks challenging. The Federal Reserve and the European Central Bank have emphasized that their primary objective is to reign in inflation. Still, banking crises’ financial impact complicates their regulatory efforts. As a result, as central banks around the globe prepare for interest rate decisions this week, there is a growing discussion about how central banks should consider the impact of banking crises when calibrating their tightening policy.

It is important to note that the current market uncertainty and volatility between what the markets expect and what central banks do will continue until they stabilize the situation. This may require central banks to think about their rate-setting power in ways beyond just fighting inflation.

The ECB’s Response

The European Central Bank was the first major authority to react when it raised key policy rates by half a percentage point on March 16, consistent with its pre-crisis plan. The President of the ECB, Christine Lagarde, clarified that the bank would continue to focus on bringing down inflation to reach its medium-term target of 2 percent. While using the interest-rate instrument, the ECB would also monitor market tensions and be ready to use its policy toolkit to supply liquidity to the financial system if necessary.

Several commentators, including former US Treasury Secretary Larry Summers, praised the ECB for raising rates amidst the financial market turmoil and separating monetary policy from financial stability concerns. “Lagarde gets an A+ today,” Summers said.

The Challenge

While conceptually appealing, separating policy objectives and instruments is not practical, as interest rates impact the economy and financial markets. Simply put, monetary policy “gets into all the cracks.” Thus, focusing on interest rates to control inflation unavoidably influences financial behavior, especially the appetite for risk.

When rates remain low for extended periods, as has been the case from the 2008 global financial crisis to the COVID-19 years, it leads to a desperate search for returns, which leads to the overvaluation of financial assets and increases financial stability risks.

Eventually, when inflation rises, central banks increase interest rates, which results in losses in fixed-income instruments and tightening financial connections, leading to reduced economic activity. If the number of bonds collected by banks and other financial institutions is significant, the losses, both realized and unrealized, will be uncomfortably significant. When combined with slowing business activity, these losses will destabilize institutions with unstable funding bases.

Therefore, central banks should consider the impact of their policies on financial stability while fighting inflation.

Related Facts

• Central banks worldwide have cut interest rates to address the COVID-19 pandemic, which could lead to hyperinflation or asset price bubbles.
• Inflation erodes the value of money, so central banks raise interest rates to make money more attractive and reduce demand, leading to lower inflation.
• Economic growth could result in high employment rates, which leads to higher wages and production costs, ultimately causing inflation.

Key Takeaway

While balancing the stability of the financial system and tackling inflation, central banks must carefully analyze their policies to ensure they don’t create financial instability.

Conclusion

Central banks have a fundamental role in supporting financial stability and controlling inflation. While it is essential to control inflation and keep prices stable, central banks must also keep an eye on the financial system’s stability to avoid creating destructive long-term consequences.