The recent bailout of First Republic Bank by JPMorgan Chase has sparked worries about the ability of central banks to control inflation. There are concerns that an extended period of elevated interest rates could reveal more weaknesses in the banking industry, and this could jeopardize overall financial stability, according to leading economists.
Monetary policy decisions by the US Federal Reserve and the European Central Bank are expected this week. However, economists warn that price pressures are likely to remain higher for longer, making it harder for central banks to navigate the trade-off between managing inflation and maintaining financial sector stability.
Frailties in the banking sector:
The collapse of Silicon Valley Bank and Signature Bank in March, followed by the seizure of First Republic Bank by the California Department of Financial Protection and Innovation over the weekend, highlights the frailties in the banking sector. Leading economists predict that financial instability is here to stay.
Karen Harris, managing director of macro trends at Bain & Company, suggests that people haven’t yet pivoted to a new era that will be structurally more inflationary. The aging demographic means that retirees who are savers aren’t saving the same way, and there’s a declining workforce that requires investment in automation, generating less capital and more demands for capital. As a result, the impulse of inflation will be higher, and real rates will be higher for longer, creating a lot of risks.
According to a recent poll of economists, approximately 75% of them believe that inflation is likely to remain elevated or that central banks may not be able to lower it to the desired levels quickly enough. This puts central banks in a precarious position of balancing their efforts to control inflation while also maintaining financial stability.
It is a challenging task as aggressive interest rate hikes by central banks can lead to a slowdown in economic growth and potentially destabilize the financial sector. Therefore, central banks need to tread cautiously, taking into account the trade-offs between managing inflation and ensuring financial stability. The delicate balance between the two objectives will become even more difficult to navigate if inflation remains stubbornly high, which could result in central banks struggling to achieve their inflation targets while simultaneously safeguarding the stability of the financial sector.
Potential pockets of instability:
Jorge Sicilia, the chief economist at BBVA Group, believes that central banks will likely want to “wait and see” how the monetary policy shift transmits through the economy after the abrupt rise in rates over the last 15 months. He also highlights the potential for “pockets of instability” that the market is currently unaware of, which may generate significant problems down the road if inflation doesn’t come down to levels close to 2 or 3%.
The recent events in the banking sector and the predictions of leading economists suggest a prolonged period of higher interest rates and financial instability. Central banks face a trade-off between managing inflation and maintaining financial sector stability, and it will become harder to navigate in the current climate.