Across the advanced economies, central banks have rightly prioritized maintaining financial stability and supporting the real economy over fighting inflation with interest-rate hikes. But with financial fragility rife and public and private leverage at all-time highs, their next big test is coming.
Since early 2020, central banks across the advanced economies have had to choose between pursuing financial stability, low (typically 2%) inflation, or real economic activity. Without exception, they have opted in favor of financial stability, followed by real economic activity, with inflation last.
As a result, the only advanced-economy central bank to raise interest rates since the start of the COVID-19 pandemic has been Norway’s Norges Bank, which lifted its policy rate from zero to 0.25% on September 24. While it has hinted that an additional rate increase is likely in December, and that its policy rate could reach 1.7% toward the end of 2024, that is merely more evidence of monetary policymakers’ extreme reluctance to implement the kind of rate increases that are required to achieve a 2% inflation target consistently.
Central banks’ overwhelming reluctance to pursue interest-rate and balance-sheet policies compatible with their inflation targets should come as no surprise. In the years between the start of the Great Moderation in the mid-1980s and the 2007-08 financial crisis, advanced-economy central banks failed to give sufficient weight to financial stability. A prime example was the Bank of England’s loss of all supervisory and regulatory powers when it was granted operational independence in 1997.
The result was a financial disaster and a severe cyclical downturn. Confirming the logic of “once bitten, twice shy,” central banks then responded to the COVID-19 pandemic by pursuing unprecedentedly aggressive policies to ensure financial stability. But they also went far beyond what was required, pulling out all the policy stops to support real economic activity.
Central banks were right to prioritize financial stability over price stability, considering that financial stability itself is a prerequisite for sustainable price stability (and for some central banks’ other target, full employment). The economic and social cost of a financial crisis, especially with private and public leverage as high as it is today, would dwarf the cost of persistently overshooting the inflation target. Obviously, very high inflation rates must be avoided, because they, too, can become a source of financial instability; but if preventing a financial calamity requires a few years of high single-digit inflation, the price is well worth it.
I hope (and expect) that central banks – not least the US Federal Reserve – are ready to respond appropriately if the US federal government breaches its “debt ceiling” on or around October 18. A recent study by Mark Zandi of Moody’s Analytics concludes that a US sovereign debt default could destroy up to six million US jobs and wipe out as much as $15 trillion in US private wealth. This estimate strikes me as optimistic. If the sovereign default were to be protracted, the costs would probably be much higher.
In any case, a US sovereign default would also have a dramatic and devastating global impact, afflicting both advanced economies and emerging and developing markets. US sovereign debt is widely held globally, and the US dollar remains the world’s senior reserve currency.
Even without a self-inflicted wound like a US congressional failure to raise or suspend the debt ceiling, financial fragility is rife nowadays. Household, corporate, financial, and government balance sheets have grown to record highs this century, rendering all four sectors more vulnerable to financial shocks.
Central banks are the only economic actors capable of addressing the funding and market-liquidity crises that are now part of the new normal. There is not enough resilience in non-central bank balance sheets to address a fire sale of distressed assets or a run on commercial banks or other systemically important financial institutions that hold liquid liabilities and illiquid assets. This is as true in China as it is in the US, the eurozone, Japan, and the United Kingdom.
China’s real-estate bubble – and the household debt secured against it – is likely to implode sooner or later. The dangerously indebted property developer Evergrande could well be the catalyst. But even if Chinese authorities manage to prevent a full-fledged financial meltdown, a deep and persistent economic slump would be unavoidable. Add to that a marked decline in China’s potential growth rate (owing to demographics and enterprise-hostile policies), and the world economy will have lost one of its engines.
Across the advanced economies (and in many emerging markets), risk assets, notably equity and real estate, appear to be materially overvalued, despite recent minor corrections. The only way to avoid this conclusion is to believe that long-run real interest rates today (which are negative in many cases) are at or close to their fundamental values. I suspect that both the long-run real safe interest rate and assorted risk premia are being artificially depressed by distorted beliefs and enduring bubbles, respectively. If so, today’s risk-asset valuations are utterly detached from reality.
Whenever the inevitable price corrections materialize, central banks, supervisors, and regulators will need to work closely with finance ministries to limit the damage to the real economy.
Significant deleveraging by all four sectors (households, non-financial corporates, financial institutions, and governments) will be necessary to reduce financial vulnerability and boost resilience. Orderly debt restructuring, including sovereign debt restructuring in several highly vulnerable developing countries, will need to be part of the overdue restoration of financial sustainability.
Central banks, acting as lenders of last resort (LLR) and market makers of last resort (MMLR), will once again be the lynchpins in what is sure to be a chaotic sequence of events.
Their contributions to global financial stability have never been more important. The goals of 2% inflation and maximum employment can wait, but financial stability cannot. Since LLR and MMLR operations are conducted in the twilight zone between illiquidity and insolvency, these central-bank activities have marked quasi-fiscal characteristics. Thus, the crisis now waiting in the wings will inevitably diminish central bank independence.