The Bank of England is faced with the sort of choice that central bankers prefer not to confront. Inflation is far too perky, which warrants higher interest rates. The global financial system, however, is in an unexpected state of stress: the financial “central heating” is on the blink. Past financial upheavals might suggest the need for interest rate cuts.
There has been much talk about a repeat of 2008, the year in which Lehman Brothers failed and the global financial crisis became a hideous reality. But the comparison can only be taken so far. Back then, there was a massive loss of trust in assets that, hitherto, had been snapped up with enthusiasm: those who thought they had piles of nice, safe, collateralised debt obligations on their balance sheets discovered that what was once safe was now highly toxic.
Today, the concern is about the exposure of financial institutions to the effects of rapidly rising interest rates. That is a direct consequence of higher than expected inflation.
If financial instability leads ultimately to falling stock markets and reduced bank lending, inflationary angst might be replaced by deflationary reality. Then, interest rate cuts could be justified because of both financial instability and an easing of price pressures.
Most examples of financial upheaval suggest otherwise. The October 1987 stock market crash led to a temporary easing of monetary policy but, within months, interest rates were rising again.
Eleven years later, the failure of Long Term Capital Management, a major US hedge fund, and a Russian debt default triggered an easing of US monetary policy but soon rates were heading up again as the Federal Reserve attempted to tackle a (by now) huge dot.com bubble.
At home, the “secondary banking crisis” in the early Seventies gave the Bank of England a huge headache. A whole host of often-tiny new banks appeared in the late Sixties, many of which took advantage of a combination of low borrowing rates and high returns on property investments to make what appeared to be bumper profits.
Reforms in the early Seventies, however, ended credit rationing for the major clearing banks. This triggered a huge monetary expansion and, with it, a big increase in inflation. The authorities were forced to raise borrowing costs, even though higher interest rates were an obvious consequence of the earlier deregulation.
Many of the “secondary” banks eventually found themselves in big trouble as the gap narrowed between a rapidly rising cost of funds and a falling return on investments. The Bank of England, alongside the major banks, was forced to launch what became known as the “Lifeboat” to prevent a financial meltdown.
While this proved to be a big financial shock, it did nothing to help bring inflation under control. Indeed, to the extent that the UK authorities feared further financial upheavals, there was a marked reluctance to tighten monetary policy sufficiently. That is one reason (among many) why UK inflation in the mid-Seventies was so much worse than inflation elsewhere.
The problem, of course, is that nothing seems normal in the middle of a financial storm. At that moment, the main priority is preserving the financial infrastructure. Success, however, typically leads to a return of “business as usual”, at least as far as the financial plumbing is concerned. Yet that means the fight against inflation eventually has to resume.
The secondary banking crisis was a consequence of overly loose monetary conditions and lax regulation which triggered a series of, in hindsight, foolish financial bets alongside an increase in inflationary pressures. Prioritising one part of the problem — the subsequent financial instability — made it harder to fix the other part of the problem, excessively high inflation.
At the start of the pandemic, monetary policy was, once more, overly loose. Central banks had persuaded all and sundry that deflation, not inflation, was the only significant threat. When it turned out that central banks were wrong, the world changed: we now have higher inflation, higher interest rates and, in another throwback to an earlier era, moments of heightened financial fragility.
Stephen King (@kingeconomist) is HSBC’s senior economic adviser. His new book, We Need to Talk About Inflation (Yale), will be published in April.
