As a result, Norway’sNorway’s Norges Bank is the only advanced economy whose central Bank has raised the interest rate since the start of the COVID 19 pandemic.
The benchmark interest rate of zero on September 24 increased to 0.25%. The Bank hinted that another rate hike in December was likely and that its key interest rate could reach 1.7% by the end of 2024.
This is further evidence of the extreme reluctance of monetary policymakers to implement the kind of interest-rate hike needed to achieve the 2% inflation target.
New York Project Syndicate In early 2020, central banks in most advanced economies had to choose between financial stability and low or even below 2% inflation and actual economic activity. They have opted for financial stability, followed by real economic activity and, finally, inflation with a few exceptions.
Since the onset of the Great Moderation in the mid-1980s and the 2007-08 financial crisis, the advanced-country central banks have failed to attach enough weight to financial stability. The result was financial catastrophes and severe cyclical downturns. Today, risk and asset valuations are disconnected from reality. The overwhelming reluctance of central banks to pursue interest rates and balance-sheet policies consistent with their inflation targets should not come as a surprise. A prime example is the loss of the Bank of England’sEngland’s supervisory and regulatory powers after it was granted operational independence in 1997.
Central banks are right to prioritize financial stability over price stability as financial stability itself is a prerequisite to sustainable price stability and should, among other things, target full employment. To confirm this logic, the timid central banks have responded to the COVID 19 pandemic with unprecedented aggressive policies to ensure financial stability. But they will also be forced to withdraw from policies that are no longer capable of supporting actual economic activity.
The economic and social costs of a financial crisis – for private and public debt as it is today – dwarf the costs of overshooting the inflation target. High inflation rates can be avoided before they become a source of financial instability, but preventing financial catastrophes will require a few years of high single-digit price increases to pay off.
A recent study from Moodys Analytics by Mark Zandi suggests that a default could destroy up to 6 million US jobs and up to $1.5 trillion in private wealth. These estimates strike me as overly optimistic.
US Treasuries are held in US dollars, which remain the world’s primary reserve currency. If the US defaulted, both developed and emerging and developing countries would be hit by dramatic and devastating global effects. A sovereign default would be protracted and the costs high.
Central banks are far from the only economic actors able to deal with financing and market liquidity crises as part of the new normal. This applies to China, the US, the eurozone, Japan, and the United Kingdom. However, the resilience on the balance sheets of non-central banks is not sufficient to address the emergency sales of non-performing assets by commercial banks and other major financial institutions with liquid liabilities and illiquid investments.
Although the Chinese authorities have avoided a full-blown financial meltdown, a deep and prolonged economic downturn is inevitable. Add to that a significant decline in its potential growth rate, owing to demographic, entrepreneurial, and hostile policies, and the global economy loses one of its engines. China’sChina’s real estate bubble, and the associated household debt, are likely to implode. Debt-laden property developers and Evergrande will be the catalyst.
How can a crisis be avoided?
Central banks, administrators, and governors will require to operate strictly with the investment departments handling this necessary rate improvement to decrease the loss to the real economy. As part of the long-overdue restoration of economic sustainability, an orderly debt restructuring is also required, including restructuring sovereign debt in several vulnerable developing countries.
Targets of 2% inflation and maximum employment will have to wait, but financial stability will not.
Its contribution to global financial stability has never been more critical. As lenders of last resort (LLR) and market makers of last resort (MMLR), central banks are the linchpin of what is likely to be a chaotic sequence of events.
LLR and MMLR operations are conducted in the twilight zone of illiquidity and insolvency and are characterized by quasi-fiscal characteristics. The crisis is just around the corner and weakens the independence of central banks. The targets of 2% inflation and maximum employment are still outstanding, but financial stability is not.