Inflation Targets Have Left Central Banks in a Bind

The collapse of Silicon Valley Bank exposes the challenges central banks face in implementing effective monetary policy. Whether inflation targets should be raised to reduce the risk of a recession continues to divide experts. In this article, we take a closer look at the issue and provide our opinion.

Deflationary Forces and Ultra-Low Interest Rates

The period following the financial crisis of 2007-2009 presented central bank policymakers with a unique challenge. Deflationary forces were rampant, focusing on raising inflation to the target level. Central banks resorted to ultra-low and sometimes negative nominal interest rates to achieve this.

The problem, however, was the market distortions that followed, with prices of almost all assets, including long-dated mortgage-backed securities, being propelled to astronomic heights. As a result, investors were driven to search for yield, regardless of the risk.

And that was the story of Silicon Valley Bank, which saw a tidal inflow of deposits during the tech boom, far exceeding potential lending opportunities. As a result, the bank had to find investment outlets for the money, and with short-term paper offering next to nothing, it locked up funds in mainly highly-rated long-dated mortgage-backed securities.

The Risk of Rising Interest Rates

Long-dated instruments are particularly vulnerable to rising interest rates, and Silicon Valley Bank faced a crisis after the Fed tightened monetary policy in response to unexpectedly high inflation. The decline in the mark-to-market value of the bank’s portfolio nearly wiped out its capital.

Even though depositors would have suffered no losses if the securities were held to maturity, the tech community panicked, leading to a run on deposits. Silicon Valley Bank was forced to sell the devalued assets, precipitating its bankruptcy.

We may now be at the start of a series of financial instability episodes as central banks wrestle to bring inflation back to 2%. This is giving rise to arguments for raising inflation targets to 3% to help avoid such events in the future.

Moving the Goalposts

Raising inflation targets from 2% to 3% is not an unreasonable proposal if, as former Bank of England chief economist Andy Haldane suggested, there is a shift upwards in the global equilibrium price level. However, there is, in fact, no theoretical justification for equating 2% with price stability.

However, such a move would be seen as relinquishing the fight against inflation. Central banks’ already depleted credibility would be further hit, and inflation expectations would soar. The possible solution would be to follow Haldane’s suggestion of either extending the time horizon to meet the 2% target or temporarily suspending it while promising to refix it as soon as possible.

Related Facts

• Central banks face challenges in implementing effective monetary policy
• Deflationary forces present a unique challenge for policymakers
• Ultra-low interest rates can result in market distortions and asset bubbles
• The collapse of Silicon Valley Bank highlights the risks of investing in long-dated instruments
• The argument for raising inflation targets to 3% is gaining support

Key Takeaway

Inflation targets have left central banks in a bind. While ultra-low interest rates were necessary to raise inflation to the target level, they have also led to market distortions and asset bubbles. The collapse of Silicon Valley Bank highlights the risks associated with investing in long-dated instruments. Raising inflation targets to 3% may help avoid similar events in the future, but doing so risks further damaging the credibility of central banks.

Conclusion

We all want financial stability, but it is challenging for central banks. The collapse of Silicon Valley Bank is a stark reminder of the risks of investing in long-dated instruments when interest rates are expected to rise. Raising inflation targets to 3% is a possible solution, but it would be seen as giving up the fight against inflation. So central banks must walk a fine line between pursuing the right monetary policy and maintaining the markets’ confidence.