Global Economic Weekly

March 17, 2023

Ethan Harris, Head of Global Economics, BofA Global Research

Central Banks Can Walk and Chew Gum

By some accounts central banks are now walking an almost impossible tightrope. They were behind the curve in fighting inflation and now need to restore their credibility. Hence, "flip-flopping" on the pace of rate hikes is verboten, pausing and then hiking is even worse and worst of all is easing policy to address financial market volatility. Here we make three points: (1) central banks have particularly strong tools when the challenges originate in the banking sector, (2) central banks can walk and chew gum – there is nothing wrong with using lender of last resort tools to address banking concerns and rate hikes to deal with an overheating economy and (3) there is also nothing wrong – or unusual – about lowering rates in the short term to stabilize markets and then resuming rate hikes later to finish the job of corralling inflation.


The credibility cost of waiting too long

With a good bit of 20-20 hindsight, central banks have faced heavy criticism for hiking too late and letting the inflation genie out of the bottle. However, it is worth remembering that some of the inflation surge reflected forces that virtually no one anticipated. Moreover, central banks were far from alone in thinking that the Phillips curve was essentially dead and there was little risk in testing the limits of full employment. That was the consensus . . . until proven wrong.


Now central banks allegedly have a major credibility problem that ties their hands. Restoring credibility requires a laser focus on fighting inflation, with a well-choreographed steady diet of rate hikes. Anything else will undermine their credibility crusade.


A foolish consistency is the hobgoblin of little minds

We disagree. With such a fluid backdrop in markets and the economy, central banks can't afford to box themselves in. They need to be flexible in changing course as conditions change. That means "flip-flopping" is a virtue, not a vice. It shows that the central bank is willing to reassess on the fly.


Perhaps the ultimate flip-flop would be for central banks to pivot from fighting inflation to restoring stability in capital markets. The good news is that central banks and other regulators are well equipped to deal with a crisis that originates in the banking sector, as opposed to say the popping of an asset bubble. They can "walk and chew gum," using targeted tools to stabilize the financial world and (carefully) hiking rates to lean against inflation.


What if targeted support is not enough? Here again, the popular narrative misses the mark. There is a simply way for central banks to create an extra degree of freedom. The answer is to cut rates (and perhaps stop balance sheet shrinkage) in the short-term to stabilize markets but leave open the option of retightening policy if overall financial conditions ease. It is hard to get this just right in practice: the goal is to create modestly tight overall financial conditions over the medium term. This requires balancing the impact of risk-off behavior in the financial system against the level of rates (and other actions) by the central bank. In an ideal world policy would always move linearly; in the real world policy makers need to be flexible.


A shifting balance of risks and a third option

Our baseline calls for the major central banks have not changed in the past week. Hence after hiking 50 bp yesterday, European Economist Ruben Segura and team expect another 100 bp of rate hikes from the ECB (European Central Bank) in the next few months. In our view, with hawks steering the boat, the ECB is more likely than other central banks to stay the course. Indeed, at yesterday’s press conference the ECB's President Lagarde made the somewhat exaggerated claim that there is "no trade-off between price and financial stability." As we have seen, given the inherent nonlinearity of financial events, sometimes stabilizing the markets means delaying the inflation fight.


US Economist Michael Gapen and team still expect the Fed to hike by 25 bp at each of the next three meetings. However, if volatility continues into the meeting the Fed could pause. Our US Economics team think the balance of risk around the baseline policy path has shifted from “predominately to the upside” to “more balanced and wider.”


The markets seem to have a very binary view of the options facing central banks: either (1) the hiking cycle is over and cuts are coming, or (2) they are going to continue steady rate hikes. There seems to be no discussion of the third option – temporary cuts. While that is not our base case and it is not something central banks like to do, we think it is a plausible scenario, particularly for the Fed.

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