Will financial stability concerns derail the Fed’s inflation fight?

There is a growing chorus of calls for the Federal Reserve (the Fed) to take its foot off the accelerator and bring about an early end to the current rate-hike cycle. Some are fearful that the rapid pace of monetary tightening will lead to financial instability and risk a much harder landing for the U.S. economy than currently envisioned. Others fret about the risks posed to the entire global economy by a surging U.S. dollar (driven ever higher by expectations of widening cross-border interest rate differentials).

Yet, the latest Consumer Price Index report suggests that U.S. inflation remains stubbornly high and appears to have dashed hopes for an early pivot by the Fed. A fourth consecutive 75-basis point rate hike appears to be on the cards at the next Federal Open Market Committee (FOMC) meeting, which should push the federal funds rate target range to between 3.75 percent and 4 percent by early November.

Should the Fed stay the course and prioritize the battle against unacceptably high inflation? Or should it heed the calls for a policy recalibration in light of growing fears that something might break and push us into a deep recession? To address the question, it is worth examining the arguments of both sides of the debate.

Having raised interest rates by 300-basis points since March, the Fed, argue Paul Krugman and Joseph Stiglitz, among others, may be pushing up rates too far and too fast and as such raising the prospect of overtightening. Besides highlighting the need to let the already implemented rate hikes work through the system and cool aggregate demand, those calling for a pause note that certain interest-rate-sensitive sectors, such as housing, have already weakened sharply.

Fed Vice Chair Lael Brainard also acknowledged the cross-border spillover risks and financial contagion fears in a recent speech: “U.S. monetary policy tightening reduces U.S. demand for foreign products, thus amplifying the effects of monetary tightening by foreign central banks,” she said. “The same is true in reverse: Tightening in large jurisdictions abroad amplifies U.S. tightening by damping foreign demand for U.S. products. Tightening in financial conditions similarly spills over to financial conditions elsewhere, which amplifies the tightening effects.”

Meanwhile, Jason Furman and others have made the case that the Fed should stay the course and continue to prioritize the battle against high inflation. Atlanta Fed President Raphael Bostic in a recent speech made the case for staying resolute and avoiding the stop-and-go monetary policy of the 1970s. Larry Summers has argued that underlying strength in the labor market and elevated wage pressures necessitates further rate hikes.

While arguments made by both sides of the debate have merit, the question of whether the Fed risks overtightening monetary policy is impossible to determine ex-ante. As recent events in the United Kingdom and elsewhere have highlighted, financial instability risk continues to grow. Warren Buffett’s famous remark that you only find out who is swimming naked after the tide goes out suggests that hidden financial risks may pose unexpected challenges as major global central banks race to tighten credit and liquidity conditions.

It is the “unknown unknowns” that often derail the best laid plans of policymakers. Even the world’s largest bond market is showing signs of duress as liquidity evaporates and volatility spikes in the U.S. Treasuries market. Even the supposed strength in the labor market might be a sign of underlying dysfunction and low labor productivity.

Yet, the Fed cannot afford to take its foot of the accelerator as we enter a new era of secular inflation. Structural forces that were primarily disinflationary over the past four decades are now shifting towards becoming persistently inflationary, and this requires a dramatic rethink among financial market participants and central bankers.

Having unnecessarily delayed the implementation of policy tightening in 2021, when circumstances were much more favorable, the Fed is now stuck between the proverbial rock and a hard place. If it fails to deliver on its promise to bring inflation back down towards the 2 percent target level, it risks further eroding central bank credibility. On the other hand, if it keeps tightening until something breaks, it risks pushing the U.S. and the global economy into a severe downturn.

A middle ground may still exist if the Fed decides to make appropriate use of forward guidance. Once rates are pushed up towards 4.5 percent (by December), the Fed should announce a long pause. But to make sure that long-term market rates do not overreact and undo all the painful work undertaken so far, it is necessary for the Fed to explicitly commit to not consider rate cuts until headline PCE inflation rate drops down to the 2 percent to 2.5 percent range and remains near those levels for at least a quarter.

Given the enormous pile of public debt and sizable non-financial corporate debt, it is unlikely that systemic financial risk can be avoided if rates get pushed up too far. Yet, the battle against inflation is far from over. Pre-emptive easing or stop-and-go monetary policy would result in a repeat of the 1970s. A compromise where a modest terminal rate of 4.5 percent is attained quickly but maintained for an extended period of time might offer the best alternative under the present challenging circumstances.

Vivekanand Jayakumar is an associate professor of economics at the University of Tampa.