The Silver Bullet - No. 4

Stuck in the Middle With You

Central bankers are stuck.

After over a decade of free money, monetary policy has come to a breaking point. Policymakers will soon have to choose between price stability and financial stability.

Stuck in the Middle With You

March 2023

The role of financial stability in central banking has been underestimated since the Greenspan approach of ‘stimulate today, deal with the consequences later’. But a handful of central bankers flagged the risks of inflating bubbles in the name of stimulus. 

And yet, the lessons learned during the 2008 crisis seem to have been forgotten. With prolonged Quantitative Easing, QEinfinity, monetary policy helped to inflate asset bubbles in and outside the banking system, from crypto to real estate. These bubbles now threaten the normalisation of policy.

Today, the financial system is dealing with the long-term consequences of rational bubbles, including increased wealth inequality and increased social and geopolitical tensions.

This means policymakers won’t get all they want this time around. On the one hand, tightening too little could leave the economy drifting into a high inflation regime. On the other hand, tightening too much might push the financial system into a credit crunch and economy into a recession.

Some central banks are choosing price stability. The ECB is a case in point, having spent years stress-testing banks and defusing the sovereign-bank nexus, which contributed to the 2011-2012 banking crisis. Other central banks won’t be able to do the same: with rising government and household debt, the Bank of England continues to keep its bank rate deeply below inflation, which recently climbed back above ten percent. And what will the Fed do?

These are our key takeaways.