Trade-off facing central banks now clear and immediate

By Jean Boivin and Alex Brazier | We’ve said for some time that getting inflation down to central banks’ 2% target would cause both economic and financial damage. The Fed has embarked on the fastest rate-hiking cycle since the early 1980s, and the European Central Bank (ECB) in its history, putting an end to more than a decade of ultra-low interest rates. The cost of these hikes is now materializing. The failure of two regional banks, pressures on a major Swiss bank and the surge in UK government borrowing costs last year are important examples.

Will central banks choose to divert monetary policy from fighting inflation to protecting the banking sector? We don’t think so – and that’s very different from any other financial stress episode in the past 40 years. Here’s why.

When you consider the size and speed of central banks’ rate hikes, it was clear that would cause economic damage and uncover financial cracks of some kind.

A comparison with the past reveals just how restrictive monetary policy is becoming for economic activity, especially in the U.S. A proper comparison needs to look at borrowing costs in real terms, that is after accounting for the value erosion from inflation. We also need to account for the fact that the winding down of central banks’ asset purchases – often referred to as quantitative tightening – is increasing the cost of borrowing. If you translate that impact into an equivalent rate hike and add it to the real policy rate, you get the “real, shadow rate” – and it’s currently about 0.5-1 percentage points above the policy rateⁱ.

We think that rate will reach around 2.5% in the U.S. by the middle of the year. By comparison: from 2008 to 2019, the real shadow rate averaged around -3%. See the Rapid rate rises chart. When you also consider the downward trend in interest rates over the last 20 years, that makes monetary policy the most restrictive it’s been since the 1980s.

The Fed knew when it embarked on this rate hiking campaign that it would trigger damage. We think its arrival – even if in unexpected places – is what was always needed if it wanted to get inflation down quickly.

Why have central banks raised rates so quickly, given the cost? Since the pandemic, they have faced a starker trade-off between controlling inflation and protecting growth. Supply constraints mean developed economies are no longer able to produce as much without sparking inflation. As central banks are not able to solve supply constraints, the only way they can get inflation down closer to their target is to crush demand so it drops down to match what the economy can comfortably produce – in other words, recession.

In the U.S., one supply constraint in particular isn’t going away and is keeping that starker trade-off very much alive: a labor shortage means wages are rising rapidly as employers fight for workers. And since wages account for a large chunk of the price of services, services inflation is still creeping higher. This week’s U.S. inflation data for February showed that core inflation – which excludes food and energy – is still very high, and core services inflation excluding shelter is running close to 6% on an annual basis. Inflation is nowhere near on track to settle back at the Fed’s 2% target. Recession remains the only way to get it on track, in our view: that would reduce demand for labor and ease pay pressures.

Central banks could have adopted a more flexible approach to returning inflation to target. But they have now long been all in on the inflation-fighting side of the trade-off. Without having laid the ground for it, walking back on their whatever-it-takes commitment to fighting inflation now would threaten their credibility. Turbulence in the banking sector doesn’t change the trade-off they’re facing; it’s a manifestation of it. They made their choice to fight inflation despite the costs. And given that inflation is still far from target, they have to accept these costs.

This is why we think the Fed, like the ECB this week, will be at pains to make clear that acting to contain the fallout of the bank failures is not at odds with its inflation fight. That will involve drawing a clear distinction between the tools it’s using for each objective.

On the banking front, the Fed has moved swiftly, together with the U.S. Treasury, to prevent problems spreading to other banks, to provide funding to banks facing deposit outflows and to ensure that those with money in the failed banks can still access their deposits. It will be looking closely in the coming days at how successful those measures have been at stabilizing the banking sector. In our view, the greater the success of those measures, the greater the Fed’s resolve will be to continue its inflation fight.

On the inflation side, the Fed’s key tool remains interest rates. We see it continuing to use that tool so long as inflation is not on a sustainable path back towards 2%.

This separation of goals contrasts with the central bank response to the 2008 bank failures and to the pandemic when they used all their tools – including rate cuts – to stimulate the economy as much as possible.

Why a different approach now? The trade-off means the Fed is actively generating recession this time, not trying to avoid it. This approach is not dissimilar to how the Bank of England responded to instability in the UK government bond market at the end of last year: it took specific measures to restore financial stability (with temporary purchases of assets in that case), while continuing to hike rates to rein in inflation.

We don’t expect central banks to start cutting rates this year: they won’t rescue the economy from a recession they have actively engineered. In fact, we expect further hikes as they keep going with their inflation fight. Indeed, the ECB raised its interest rate by a further 0.5% yesterday. That’s a clear break from the past when it would not have hiked in such a tumultuous week of bank troubles.

More hikes, plus the lagged impact of the hikes already done, means further economic and financial damage is coming. Recession is foretold. We do think there will come a point when that damage will force central banks to halt their hiking campaigns – when the trade-off becomes too painful and the separation of inflation-fighting and financial stability objectives becomes untenable. But we’re not there yet.

That said, this episode could mean it comes a little sooner, meaning central banks won’t take rates as high as they otherwise would have. How much lower the end point of rate hikes is largely depends on how much this episode dents confidence and bank lending. Central banks are hiking precisely to tighten financial conditions – i.e. make saving relatively more attractive than borrowing – so that people and firms spend less and the economy slows down, in turn cooling off inflation A drying up of lending would do some of that work for it. This week’s indications of deposits moving out of parts of the U.S. banking system points to a reduction in lending ahead.

In any case, whenever central banks reach their tipping point, we think it will be before inflation is back on track to 2% – especially in the U.S. – despite their assertion now that they’ll not stop hiking until it is. End result? Inflation ultimately settling somewhere closer to 3%. In the meantime, with inflation not yet on track even to 3%, the Fed and ECB will stay still all in on their inflation fight – even if things break along the way.