Central banks should raise the bar for intervention

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The writer is a former central banker and a professor of finance at the University of Chicago’s Booth School of Business

Few would begrudge the mildly celebratory tone in US Federal Reserve chair Jay Powell’s speech at Jackson Hole on Friday. Dire predictions that the Fed would have to raise policy interest rates and unemployment sky high in order to bring inflation under control have not been borne out.

Of course, the Fed cannot yet declare mission accomplished, and it may be that the last mile is hardest given ongoing services and housing inflation. But the American central bank has come a long way from the 9 per cent CPI inflation in June 2022 to the below 3 per cent read last month. As we try to understand how this happened, there remains a potential risk we cannot ignore. 

The pandemic and the war in Ukraine disrupted supply. The pandemic also initially skewed demand for goods, and then for services as economies opened up. The resulting imbalances caused inflation. Much of the subsequent disinflation has occurred because supply and demand imbalances readjusted naturally, without Fed influence.  

However, over and above all this, the level of demand expanded post-pandemic because of confident household spending and the huge, and continuing, fiscal spending by the US government. The Fed’s higher rates played a part in curbing some of this demand — new housebuilding has come down significantly since the central bank started raising rates.

In other sectors like automobiles, however, sales have risen since the Fed began to raise rates. That the Fed’s efforts to contain demand are only part of the story is corroborated by the Chicago Fed’s financial conditions index, which provides a summary of how tight money markets, debt and equity markets and the traditional and “shadow” banking systems all are. In fact the index is easier today than its average this century, at a time when the Fed suggests its policy is quite restrictive.

The reason the Fed has not had to constrain demand more is that the US economy has benefited from an expansion in supply due to immigration and productivity improvements. So disinflation has been accompanied by steady growth, with the economy thus far on course for the proverbial “soft landing”. Anticipation of such an outcome partly explains why financial markets have not responded adversely to the Fed’s tightening.

There is another reason, though. Over the benign pre-pandemic period of easy financial conditions, while household and corporate debt fell relative to GDP, a number of financial players tried to goose up returns by taking on additional financial risk, leveraged further with borrowing. Sometimes the leverage was implicit in the kinds of investment or trading strategies pension funds and hedge funds adopted. When the pandemic hit in March 2020, this prompted a “dash for cash”. Central banks came to the rescue by expanding money-like reserves hugely, cutting rates and establishing extraordinary lending programmes. 

Consequently, explicit and implicit financial sector leverage never really came down. Even as central banks turned to withdrawing accommodation through rate increases and shrinking their balance sheets, they have not been averse to stepping back in. When mid-sized US commercial banks got into trouble in March 2023, the Treasury implicitly insured all uninsured deposits, while the Fed and the Federal Home Loan Banks lent freely, thus stopping the panic. Most recently, as Japanese markets tumbled, Bank of Japan governor Kazuo Ueda indicated the BoJ would not raise rates if markets were unstable.

Usually, it takes an economic downturn or a financial panic to purge excess leverage from financial markets. If central banks achieve a soft landing, markets will have seen neither even as they are further buoyed by rate cuts, which will prompt further leveraging. With central banks continuing to shrink their balance sheets, the system’s leverage to cash ratio will keep growing, raising the chances of a sharp reaction to any bad news — be it a worrisome turn in the trade wars, a troubling presidential election, or geopolitical tensions. Economic stabilisation may, paradoxically, raise the chances of financial instability.

None of this, of course, is to suggest that central banks should engineer an economic downturn to cleanse the financial system. It does mean, however, that they should raise the bar on intervening whenever it gets into trouble. As with forest fires, small conflagrations can prevent a larger one. Even as the central bankers at Jackson Hole take a justified anticipatory bow, they should also worry a little about what their achievement will imply.