On financial dominance

The importance of preserving financial stability

Should central banks raise interest rates in the presence of elevated financial market stress? This is the question Costas Milas explores in this commentary. He argues that research shows that in the case of the UK rising financial stress suppresses UK GDP growth for up to 20 months, while for the U.S. , a recent ECB working paper, shows that an unexpected worsening of conditions in financial markets causes a decline both in output and prices.
The charts below indicate that current financial stress, after the SVB and Credit Suisse crises, is not at the levels seen in 2008, but they also show, according to Milas, the interest rate setting behavior of Central Banks: in particular, the Bank of England’s Monetary Policy Committee raises interest rates when inflation exceeds the 2% target and output exceeds potential output, but lowers interest rates when financial stress is on the rise.
Milas re-estimates a ‘monetary policy rule’ which sets interest rates based on inflation relative to the target, output relative to potential and financial stress, and finds that a temporary pause in UK interest rates (at 4%) is ‘advisable’.



Raising interest rates in periods of increasing financial stress
By: Costas Milas – University of Liverpool

The importance of preserving price stability

In this commentary, Willem Buiter argues that with U.S. core personal-consumption-expenditures inflation still at 4.7% in January, the Fed should raise its policy rate target zone by 50 bps. The ECB, according to Buiter, “got it right” last week by increasing its policy rates by 50 bps and so did the Bank of England when last fall (Liz Truss’ mini-budget crisis) engaged in temporary purchases of long-dated UK government bonds but continued raising interest rates.  So what about financial stability?

Raising the policy rate will most likely further depress the market value of long-duration securities. So be it. We don’t know how much of this duration risk was hedged by the banks (and who the counterparties to such hedging are). But we do know that bank losses (in orderly markets) due to mistaken investment decisions are part of the healthy Darwinian mechanism that sustains a market economy, as is the orderly resolution of bankrupt institutions. The central bank must be ready, as lender of last resort and market maker of last resort, to discharge its financial-stability responsibilities should illiquidity, bank runs, or other market failures pose a systemic threat.

Price Stability vs. Financial Stability?
By: Willem Buiter – Columbia University