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Amid US banking crisis, why central banks’ decision to prioritise price stability is the right move

European Central Bank has raised its policy rate by 50 basis points & US Federal Reserve by 25 basis points with the aim to bring inflation back down to target levels.

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Central banks in advanced economies are facing the policy dilemma of either raising rates to fight the persistent inflation or to go slow on rate hikes to safeguard financial stability. Aggressive rates hikes and consequent losses on bond holdings have been responsible for the recent turmoil in the US banking system.

Central banks are likely to stay the course on interest rate increases to tame high inflation. Last week, the European Central Bank (ECB) raised its policy rate by half-percentage point while also promising emergency liquidity support to eurozone banks to address financial instability.

The Federal Reserve announced another 25-basis points interest rate hike. With this move, the federal funds rate has moved from nearly zero in March 2022 to a range of 4.75-5 per cent. There was some speculation that the Fed might halt rate hikes or cut rates in response to the looming financial stability risks. But the Bank went ahead and raised rates, reaffirming its commitment towards bringing inflation to its 2 per cent target.

The summary of economic projections indicate that inflation is likely to remain elevated. In fact, the projections for inflation have been scaled higher as compared to the December projections. Monetary policy tightening is likely to continue at least for one more meeting, before the Fed hits the pause button. But rate cuts are definitely not expected this year.

Also read: Real estate over banks — where the average Indian household is putting its savings

State of the economy justified rate hike by the Fed

The Consumer Price Index (CPI) based inflation registered a growth of 6 per cent on a year-on-year basis. Excluding volatile food and energy prices, core CPI rose 5.5 per cent. The personal consumption expenditure (PCE) price index, which reflects changes in the prices of goods and services purchased by consumers in the US, also rose 5.4 per cent in January.

Graphic: Ramandeep Kaur | ThePrint
Graphic: Ramandeep Kaur | ThePrint
Graphic: Ramandeep Kaur | ThePrint
Graphic: Ramandeep Kaur | ThePrint

US consumer spending increased by the most in nearly two years in January amid a rise in wages. Non-farm payrolls, an indicator of job addition during the previous month, rose by 311,000 in February, much above the consensus expectation, indicating that the labour market is still strong. While the unemployment rate edged up to 3.6 per cent in February from 3.4 per cent in the previous month, most indicators reveal that the economy and demand is still robust and hence monetary policy has still some more work to do.

Stress in the banking sector and monetary policy stance

The Fed chair acknowledged that the recent banking stress has led to tightening of credit conditions for businesses and households and could weigh on economic activity, inflation and employment. Tighter lending standards could lead to a pullback in lending by banks. This could lower demand and would have a similar impact as rate hikes.

There was some change in the language on forward guidance as well — from “ongoing rate increases” to “some additional firming may be appropriate” — indicating that the future rate hikes would be data dependent.

Choosing between price stability and financial stability: Is there a trade-off?

The recent episode of financial distress has brought the focus back on the old policy question: should monetary policy decisions be also guided by financial stability concerns, in addition to the objective of price stability? While raising interest rates is justified based on underlying economic data on inflation and labour market, doing so could generate additional stress on bank liquidity.

Policy response and commentary by central bankers show that price stability and financial stability are two separate battles and should be fought separately.

Monetary policy is a blunt instrument for addressing financial stability concerns. It should focus on price stability. Concerns emerging from financial stress should be addressed through enhanced macroprudential supervision and timely provision of liquidity. Enhanced liquidity is being made available through Bank Term Funding Programme. As a result, the Fed’s assets have jumped sharply in the week ending March 14. Six global central banks have announced a coordinated action to enhance the provision of liquidity to ease strains in the global financial system.

What do recent actions mean for India?

The recent episodes of the banking crisis in the US and Europe have made Indian markets more volatile. The dollar index, a gauge of the strength of the US dollar against a basket of six currencies, slid after the rate hike. This will have implications for financial markets and the exchange rate. The swings in US bond yields will impact yields and prices of Indian bonds as well.

RBI has assured that Indian banks are resilient and are not going to be impacted by these episodes, but there is a need to review the exposure to bonds and mark-to-market losses of banks. There is also a need to evaluate the concentration risk of the banking sector not only on the asset side but also on the liability side.

Price stability and financial stability need to be addressed separately. In the spirit of the Tinbergen rule, which states that policy makers need to have control of at least one instrument to fulfil each objective, interest rate should be deployed for maintaining price stability and swift regulatory interventions and liquidity support to contain financial contagion.

Radhika Pandey is Senior Fellow at National Institute of Public Finance and Policy.

Views are personal.

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