Front-loading rate hikes risks financial instability

The heated debate about how central banks should respond to high and persistent inflation has focused primarily on how high interest rates should go and how long they should stay there. A third issue, that of front-loading the increases, is particularly relevant in this rate cycle. After all, central banks are seeking not just to lower inflation without damaging growth and jobs; they also have to steer a fragile financial system in which a market malfunction can damage economic well-being.

Consider the US Federal Reserve. Having badly misdiagnosed inflation last year and fallen behind its price-stability mandate, the Fed significantly intensified its policy response over the last few months. The June rate increase of 75 basis points was the first of that size in 28 years, and the Fed has followed with two similar increases, a record, with a third one expected next week.

This Fed rate-increase cycle is the most front-loaded one in a long time. The cooling housing market, the sharp rise of the dollar and the headaches caused for many countries are examples of its effects.

Yet reflecting how tardy the Fed response has been, the financial markets are pricing in an additional 1.75-2 percentage points of rate increases.

The Fed risks pushing the US economy into recession, throwing millions out of work, worsening inequality, undermining its independence, and causing economic fires around the globe. It is a concern amplified by an operational approach that relies heavily on lagging data and seems to be still governed by an outdated monetary policy framework. Yet, as worrisome is the possibility that an early “pivot” in Fed policy would risk leaving the US languishing in a stagflationary swamp.

This delicate balance between reducing inflation and limiting the hit to economic well-being becomes even more complex because of financial stability worries, including the threat of malfunction in G-7 government bond markets. The weakest links in leverage- and derivative-heavy chains have migrated out of banks to non-banks that are both less well supervised and regulated — a phenomenon illustrated a few weeks ago by the near-collapse of firms serving the UK pension system.

The faster the rate-increase cycle, the greater the risk of large financial accidents with nasty spillovers. After all, the financial system did what it was incentivised to do during more than a decade in which markets were conditioned to believe in the longevity of zero or negative rates, injected trillions of dollars of liquidity, and reinforced the belief in a “central bank put” that shielded markets not only from large asset price declines but also what was once deemed normal volatility.

The financial system’s optimisation of that regime involved large debt and leverage; over-adherence to unrealistic return objectives; and, for too many, venturing well beyond their natural investment habitat and expertise.

Inflation and the monetary policy changes it entails require an orderly reversal of this prior optimisation — something far easier said than done. That is naturally spurring concern about the pace of the Fed’s rate increases. If the Fed is not careful, well-intended policy actions could end up causing not just an economic accident (recession) but also a financial one (disorderly deleveraging and disruptive contagion across the financial system and to the real economy).

In theory, the Fed’s growth and financial stability challenges could be resolved without harming the battle against inflation by convincing markets that the rate destination remains the same but the journey will be prudently slower. In practice, this is hard for a central bank that is already associated with a “frankly disappointing lack of progress on curtailing inflation.” The Fed is stuck in a rock-versus-hard-place situation.

It is time to recognise that the speed with which interest rates are going higher for longer, while needed to curb inflation, significantly increases the risk to financial stability. If only all the earlier talk of transitory inflation, soft landings and immaculate disinflation had not delayed policymakers’ reactions and the associated repositioning of markets.

Now that time is no longer in its favour, the Fed will need even greater skill, and a lot more luck, to navigate such a complex inflation-growth-stability configuration.

(The writer is former CEO of investment management firm PIMCO and currently Chief Economic Adviser of its parent company,
Allianz) Bloomberg Opinion