Leaving the ‘region of stability’: Monetary and fiscal policies at a crossroads

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The combination of unpalatably high inflation and the financial pressures evident in the collapses of three US banks and banking giant Credit Suisse is something not experienced in decades. There is, however, a complex explanation for why the world has reached this point.

While the pandemic and central bank and governments’ responses to it were the obvious catalysts for the outbreak in inflation to 40-year high levels, and their efforts to reverse their pandemic-inducted policies have been a contributing factor to the financial stresses, there are underlying long-term developments that have led to the difficult and vulnerable position much of the developed world finds itself in today.

The general manager of the Bank for International Settlements, Agustín Carstens, gave a speech last month in which he referred to a “region of stability,” arguing that monetary and fiscal policies were testing the boundaries of that region.

Central bankers and governments are at a crossroads – risking a recession while seeking to protect prosperity and financial stability in their battle against inflation.Credit: Shutterstock

This region, he said, was a reference to the “constellations of monetary and fiscal policy that, conducted over time, support macroeconomic and financial stability and keep the inevitable tensions between the two policies manageable.”

Remaining clearly within the region prevented the policies from damaging the economy through inflation, financial stress and economic slumps.

He argued that the current challenge to the region’s boundaries was the latest in a sequence that stretched back to at least the 1970s, where at each step the policy choices seemed reasonable or even compelling.

“This reminds us that economic systems can appear stable until, suddenly, they are not,” he said.

From the 1990s onwards, globalisation, the rise of China as the world’s low-cost manufacturing hub and the deregulation of finance and the financialisation of economies – where everything that can be turned into a tradeable financial asset is turned into a tradeable financial asset – coincided with the apparent triumph of central banks over inflation.

Consistently low inflation encouraged central bankers and politicians to believe that monetary and fiscal policies could smooth out the bumps in economic outcomes, while financialisation gave markets and their participants an increasingly powerful role in economies and influence over policymaking.

Central banks helped prevent a global financial system collapse and a severe depression after deploying unconventional policies in response to the 2008 financial crisis but, in an era of ultra-low inflation and modest economic growth, kept monetary policies loose for more than a decade.

“This reminds us that economic systems can appear stable until, suddenly, they are not.”

Governments, which had pumped massive stimulus into their economies in response to the global financial crisis, had little reason to reign back their spending when the cost of debt was so low and the demand for debt by banks, investments funds, insurance companies and hedge funds was so high.

Then, of course, came the pandemic and a “whatever it takes” response from both central banks (zero to negative interest rates and more unconventional policies) and governments, which made massive transfers to households and businesses on a scale, as Carstens said, that had previously only been seen in wartime. With hindsight, both significantly overdid the stimulus.

The severe global supply chain disruptions caused by the pandemic coincided with a surge in demand from the cashed-up households, and ignited the worst break-out in inflation rates in decades.

The response, a rapid tightening of monetary policy, with interest rates rising rapidly and liquidity being drained as unconventional policies are exited, has come at a time when global debt levels are at record levels and most asset prices have been inflating strongly for more than a decade, with investors made complacent by an expectation that the central banks would always come to their aid at the first signs of stress.

Now both central banks and governments find themselves constrained.

Having committed themselves to the fight against inflation and done much of the heavy and painful lifting – the Reserve Bank just announced its 11th rate rise in this cycle and the US Federal Reserve is expected to announce its 10th this week – they can’t back off and risk high levels of inflation being entrenched.

Governments, with record levels of debt, are confronted with rapidly rising debt-servicing costs, as well as the need to co-ordinate fiscal policies with their central bank’s monetary policies.

Carstens argued that the near-term challenge and priority is price stability, and that once inflation was brought under control, financial instability would subside. There is, however, a price that households and businesses are paying and will pay from the singular focus on inflation. The “recession we had to have” in the early 1990s did generational damage.

It’s not just governments that have been caught out by the abrupt shift in macroeconomic policies.

If you look at what occurred in the UK last year, when the defined pension fund sector almost blew up overnight, or the recent collapses of the Silicon Valley, Signature and First Republic banks in the US and the forced sale of Credit Suisse to UBS, the sudden and severe rise in yields on bonds were the critical drivers of massive liquidity squeezes for institutions exposed to large holdings of low-yielding securities whose market value falls as interest rates rise.

The interaction of high and rising interest rates and reducing liquidity with low-yielding assets acquired before this monetary policy cycle began may have further to run. The financial stresses in banks and other regulated institutions are at least visible. What’s unclear is how many of these time bombs might be ticking away in the shadows of the financial system.

There will be a real and very difficult challenge for central banks if the run of bank collapses in the US continues or spreads elsewhere, or hedge funds and other non-bank institutions start blowing up.

Central bankers and government policymakers would be confronted with the choice of combatting inflation or shoring up their financial systems and economies. Monetary and fiscal policies that have essentially worked in tandem in recent decades could either retrace or diverge as the tensions between them became acute.

It is apparent that fiscal and monetary policies are operating at, or even beyond the boundaries of Carstens’ “regions of stability.” The challenge will be to manage a retreat from the wilder frontiers of those policies with as few unintended consequences (like the implosion of financial markets or even the financial system) as possible.

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