NEW YORK (Project Syndicate) – Since the start of 2020, central banks in advanced economies have had to choose between pursuing financial stability, low inflation (typically 2%), or real economic activity. Without exception, they opted for financial stability, followed by real economic activity, inflation last.
As a result, the only central bank in advanced economies to raise interest rates since the start of the COVID-19 pandemic has been Norges Bank, which raised its policy rate from zero to 0.25% on September 24. a further rate hike is likely in December and that its key rate could reach 1.7% by the end of 2024, which is just further evidence of the extreme reluctance of policy makers to enforce implements the type of rate hikes needed to achieve a constant 2% inflation target.
“Today’s risky asset valuations are totally out of touch with reality.“
The massive reluctance of central banks to pursue interest rate and balance sheet policies consistent with their inflation targets should come as no surprise. In the years between the onset of the Great Moderation in the mid-1980s and the financial crisis of 2007-08, central banks in advanced economies did not give sufficient weight to financial stability. A good example was the Bank of England’s loss of all supervisory and regulatory powers when it gained operational independence in 1997.
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Prioritize financial stability over inflation
The result was 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 policies of unprecedented aggressiveness to ensure financial stability. But they also went far beyond what was necessary, doing everything they could 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 lasting price stability (and for the other objective of some central banks, full employment ). The economic and social cost of a financial crisis, especially with private and public leverage as high as it is today, would eclipse the cost of persistently exceeding the inflation target. Obviously, very high inflation rates must be avoided, as 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.
“There is not enough resilience in the balance sheets of non-central banks to cope with a discount on distressed assets or a rush on commercial banks or other systemically important financial institutions that hold assets. liquid liabilities and illiquid assets.“
I hope (and expect) that central banks, especially the Federal Reserve, are prepared to respond appropriately if the US federal government exceeds its “debt ceiling” on or around October 18th. A recent study by Mark Zandi of Moody’s Analytics concludes that a default on US sovereign debt could destroy up to 6 million US jobs and wipe out up to $ 15 trillion in private wealth. This estimate seems optimistic to me. If the sovereign default were to continue, the costs would likely be much higher.
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In any case, a US sovereign default would also have a dramatic and devastating global impact, affecting both advanced economies and emerging and developing markets. US sovereign debt TMUBMUSD10Y,
is widely held globally, and the US dollar BUXX,
remains the world’s leading reserve currency.
Vulnerable to financial shocks
Even without a self-inflicted injury like a failure of Congress to raise or suspend the debt ceiling, financial fragility is pervasive these days. Household, business, financial and government balance sheets have reached record levels this century, making all four sectors more vulnerable to financial shocks.
“The economic and social cost of a financial crisis, especially with private and public leverage as high as it is today, would eclipse the cost of persistently exceeding the inflation target.“
Central banks are the only economic actors capable of dealing with the funding and liquidity crises of the markets which are now part of the new normal. There is not enough resilience in the balance sheets of non-central banks to cope with a discount on distressed assets or a rush on commercial banks or other systemically important financial institutions that hold assets. liquid liabilities and illiquid assets. This is as true in China as it is in the United States, the Eurozone, Japan and the United Kingdom.
China’s housing bubble and the resulting household debt risk imploding sooner or later. Dangerously indebted real estate developer Evergrande may well be the catalyst. But even if the Chinese authorities succeed in preventing a full-fledged financial collapse, a deep and persistent economic collapse would be inevitable. Add to that a sharp drop in China’s potential growth rate (due to demographics and hostile business policies), and the global economy will have lost one of its engines.
Distorted beliefs and persistent bubbles
In advanced economies (and many emerging markets) risky assets, including SPX stocks,
and real estate, appear to be materially overvalued, despite recent minor corrections. The only way to avoid this conclusion is to believe that real long-term interest rates today (which are negative in many cases) are close to their fundamental values. I suspect that the real long-term interest rate and the associated risk premia are artificially depressed by distorted beliefs and persistent bubbles, respectively. If so, the current valuations of risky assets are totally out of touch with reality.
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“The targets of 2% inflation and maximum employment can wait, but financial stability cannot.“
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 from all four sectors (households, non-financial enterprises, financial institutions and governments) will be necessary to reduce financial vulnerability and build resilience. Orderly debt restructuring, including sovereign debt restructuring in several highly vulnerable developing countries, will need to be part of the expected restoration of financial sustainability.
Central banks, acting as lenders of last resort (LLR) and market makers of last resort (MMLR), will again be the linchpins of what is sure to be a chaotic sequence of events. Their contributions to global financial stability have never been greater. The targets of 2% inflation and maximum employment can wait, but financial stability cannot. As LLR and MMLR operations are conducted in the twilight zone between illiquidity and insolvency, these central banking activities have marked quasi-fiscal characteristics. Thus, the crisis that now awaits behind the scenes will inevitably diminish the independence of the central bank.
Willem H. Buiter is Assistant Professor of International and Public Affairs at Columbia University. He was Global Chief Economist at Citigroup from 2010 to 2018.
This comment was posted with permission from Project Syndicate – Central Banks and the Looming Financial Reckoning
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