What does monetary policy look like when financial stability is at risk? – 03/22/2023 – Solange Srour

Inflation remains high in major advanced economies; and even after a significant increase in interest rates, there are no signs that the already contracted deceleration will be enough to take it to the target. Both in the US and in Europe, the monetary authorities face a relevant dilemma: they need to be more confident that this objective will be met before considering the bullish cycle to be over; but at the same time, they run the risk of increasing the financial instability they are so keen to preserve.

The academic and market consensus has evolved to recognize that financial vulnerabilities have the potential to adversely affect the real economy, especially after the predominance of very low interest rates, for decades, created numerous weaknesses and the financial regulation elaborated after the great financial crisis of 2008 was “loosened”.

Last week, the president of the European Central Bank, Christine Lagarde, highlighted that it is her priority to control inflationary pressures. Even with all the doubts regarding the effects of the turmoil in the global financial sector on economic activity, Lagarde raised interest rates by 0.5 percentage points, signaling that the next steps will depend on the evolution of the impacts of tighter financial conditions, with the most likely scenario is the continuation of high interest rates. His intention was to avoid the risk that the market would bet on “financial dominance” —a condition in which the central bank does not dare to tighten its posture in the direction of monetary policy if this is a threat to the stability of the financial system—, discouraging the inflation expectations and increasing the cost of disinflation.

In the US, the Fed, like the ECB, tried to separate instruments to deal with the two objectives: financial stability and price controls. After the authorities guaranteed deposits from two banks above the amount covered by legislation, the Fed launched a new line of credit to provide liquidity for withdrawals from the banking system and this Wednesday (22) raised the interest rate by 0.25 percentage points — for a range of 4.75% to 5.0%.

The communication makes it clear that recent developments tend to tighten credit conditions and therefore the committee will closely monitor upcoming events, changing the phrase that additional interest rate hikes would be necessary to the possibility that some tightening could still make sense. The Fed even discussed a break in this meeting and assured that all measures will be taken to guarantee the soundness of the banking system.

Unlike what happens in advanced countries, the risk of financial instability in Brazil tends to be low, because, in addition to financial institutions having good liquidity and capitalization ratios, Brazilian regulation is rigid and banking concentration facilitates inspection. That said, it is clear that a more pronounced external slowdown constitutes a negative shock to our GDP. The effects produced on inflation are dubious.

On the one hand, we can see a search for assets seen as “safe havens” and an appreciation of the dollar, which translates into domestic inflationary pressures. The impact on the real would essentially depend on the fiscal and monetary anchors. (independence from BC). On the other hand, in addition to the negative shock on domestic GDP, commodities tend to fall with the drop in global GDP, generating a deflationary impact. (which will also depend on how the real reacts to lower flows in the trade balance and in the financial account).

How should our Central Bank react to these uncertainties? With the Selic rate at 13.75%, we are in a clearly restrictive monetary policy stance and there are already signs of a slowdown in growth and some improvement in current inflation. However, the level of core inflation is still very high, and inflation expectations remain high —either because of doubts about the new fiscal framework, or because of uncertainty about what the inflation targets and the composition of the Central Bank will be in the coming years .

Without a doubt, credit conditions have worsened, but there are no indications that the economy is headed for a sudden stop, rather that monetary tightening and fiscal uncertainty are being transmitted with greater force to activity. The result of these considerations is, for our BC, until this moment, the need to keep the Selic at a restrictive level until the disinflation process is consolidated and expectations are anchored or even resume the hike cycle, if necessary, around its goals.

Navigating the waters of high inflation and the risk of financial instability requires a delicate balance on the part of the monetary authorities. On the one hand, they must act to maintain the credibility that inflation will return to target. On the other hand, they must remain committed to preventing market conditions from becoming worse, putting the economy unduly at risk. In Brazil, it is still too early to assess the possible consequences of the new external uncertainties, but the country would certainly be better prepared if it already had a credible fiscal framework and less uncertainty regarding the maintenance of the Central Bank’s autonomy.

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