Morgan Stanley Asks When Will Central Banks Worry More About Financial Stability Than Inflation

By Seth Carpenter, Morgan Stanley chief global economist

It Ain’t Over ‘Til It’s Over

Major central banks have hiked rates despite volatility in markets. They collectively said that inflation clearly means it is too soon to conclude that the hiking cycle is over. The banking sector developments haven’t stopped the hiking, and indeed, I have noted that the idea of focusing on financial stability at the expense of inflation is a false dichotomy. Central banks are deliberately tightening financial conditions in order to slow their respective economies and thereby bring inflation down…while hopefully avoiding an unnecessarily painful recession. What the banks disruption does, however, is make it harder to
calibrate the correct degree of tightening.

Inflation is clearly the priority for central banks. On March 16, the ECB noted that it projects inflation to stay “too high for too long.” Chair Powell was similarly blunt, saying that “inflation remains too high.” And even though the BoE expects inflation to fall significantly in 2Q23, it worried that a strong labor market and an improving growth outlook could reinforce the persistence of inflation. So, what’s a poor central bank to do?

Central banks’ main tool is the policy rate. Higher rates tighten financial conditions, which slows economic growth. That chain of causality becomes more important in the current circumstances, because while policy has tightened financial conditions, so too have disruptions in the banking sector. Ideally, central banks would separate the issues, using different tools to deal with macroeconomic issues versus financial stability, but they know an interaction exists. So, they are watching developments in the banking sector to see if continued rate hikes have an outsized or nonlinear effect on financial conditions. To date, their conclusion has been “no.”

The ECB did not see volatility in financial markets as a reason to pause or to do a smaller hike. Nevertheless, the ECB did not provide particularly strong guidance about what the next policy move would be. It wants more tightening of financial conditions, but it also wants to understand what is in train. Similarly, the Fed followed through on its rate hike as we anticipated, and Chair Powell was explicit that credit market tightening works in the same direction as policy tightening. According to Powell, the banking sector disruption provides restraint akin to one or two more rate hikes. Thus, the dot plot did not show more hikes than in December, despite stronger incoming economic data. Instead of focusing on one objective versus another, central banks are keeping their eyes on inflation while trying to adjust to changing financial conditions.

When would central banks worry more about financial stability than inflation? When inflation is no longer an issue, because in response to instability, the financial markets would deal such a blow to the real economy that we would experience a severe recession. If anything, the Fed told us that it was willing to absorb even more economic pain to reduce inflation than it had in the past. Not only is the Fed projecting three years of below-potential growth (2022, 2023, and 2024) to bring inflation down (almost) to target at the end of 2025, it also reduced its forecast for growth this year and next, along with a slightly higher path for policy.

So how does it end?

If disruption in the banking sector delays an extension of policy tightening, then a soft landing is still possible. Our banking analysts see higher funding costs and rising deposit betas combined with tighter lending standards restricting loan growth. This view is consonant with Powell’s. But the downside risks have gotten bigger. A broader, more persistent contraction in credit would cause a recession given that growth will be near zero in the best version of the world. And central banks will be ruling out the upper tail of possible outcomes. The ECB is clearly focused on inflation, so growth can be sacrificed, and upside surprises like last week’s PMIs will add to its resolve.

January’s strong data in the US initially led Powell to re-open the door to 50bp rate hikes. The other lesson from the past two weeks is that the “no landing” notion never made any sense.

Central banks were always going to force a landing, one way or another; the banking sector may hold the key to which kind.