Things are only getting worse for the Fed
The author is a professor of economics and public policy at Harvard University and a former chief economist at the IMF.
The Fed’s sweeping moves to keep the Silicon Valley bank collapse from becoming systemic, followed by Suisse National Bank’s sweeping lifeline for troubled Credit Suisse, left little doubt this week that financial leaders are determined to act decisively when the growing fear. Let’s leave the moral hazard for another day.
But even if the risks of financial Armageddon in 2023 have been contained, not all of the differences since 2008 are so encouraging. Inflation was not a problem at the time, and deflation—falling prices—quickly became one. Today, core inflation in the US and Europe is still on the rise, and one really needs to tighten the definition of “temporary” to argue that this is not a problem. Global debt, both public and private, has also risen sharply. This would not be such a problem if long-term real interest rates fell sharply in the future, as happened during the years of stagnation until 2022.
However, unfortunately, this time you can not count on ultra-low interest rates on loans. First of all, I would say that if you look at the long-term historical patterns of real interest rates (as Paul Schmelzing, Barbara Rossi, and myself did), major shocks—for example, the sharp drop after the 2008 financial crisis—tend to disappear over time. There are also structural reasons: first, global debt (public and private) has skyrocketed since 2008, partly as an endogenous response to low rates, partly as a necessary response to the pandemic. Other factors that are pushing up long-term real rates include the huge green transition costs and the coming increase in defense spending around the world. Rising populism is likely to help mitigate inequality, but higher taxes will dampen the upward trend, even as higher spending increases upward pressure on rates.
This means that even after inflation falls, central banks may need to keep overall interest rates higher over the next decade than in the previous one, just to keep inflation stable.
Another significant difference between now and post-2008 is China’s much weaker position. Beijing’s fiscal stimulus since the financial crisis has played a key role in supporting global demand, especially for commodities, but also for German manufacturing and European luxury goods. Much of that money went into real estate and infrastructure, a huge, fast-growing sector in the country.
Today, however, after years of building at breakneck speed, China is facing the same diminishing returns that Japan began to experience in the late 1980s (the famous “bridges to nowhere”) and the former Soviet Union in the late 1960s. . Add to this excessive centralization of decision-making, extremely unfavorable demographics and creeping de-globalization, and it becomes clear that China will not be able to play such a huge role in containing global growth during the next global recession.
Last but not least, the 2008 crisis occurred during a period of relative global peace, which is hardly the case today. Russia’s war in Ukraine was an ongoing supply shock, which is a large part of the inflation problem that central banks are now trying to deal with.
Looking back at the last two weeks of banking stress, we should be thankful it didn’t happen sooner. With central bank rates soaring and the economic downturn, there will inevitably be a lot of business and debt losses, usually in emerging markets. So far, several low-income countries have defaulted, but there are likely to be more. There are sure to be other challenges besides technology, such as the commercial real estate sector in the US, which is suffering from rising interest rates, even though large city office occupancy is only about 50 percent. Of course, the financial system, including the loosely regulated “shadow banks”, must bear some of the losses.
Governments in advanced economies are not necessarily immune. They may have “ended” the sovereign debt crisis a long time ago, but not a partial default due to unexpectedly high inflation.
How should the Federal Reserve weigh all of these issues when deciding on its interest rate policy next week? After the banking turmoil, it certainly isn’t going to push ahead with a 50 basis point (half a percentage point) rise, as the European Central Bank did on Thursday, surprising the markets. But then the ECB is playing catch-up with the Fed.
At the very least, the optics of re-rescuing the financial sector while tightening the screws on Main Street is not very good. However, like the ECB, the Fed cannot lightly ignore sustained core inflation above 5 percent. He will likely opt for a 25 basis point increase if the banking sector appears calm again, but if there is still some turmoil, he may well say the direction is still up, but he needs to pause.
It is much easier to contain political pressure in an era when global interest rates and price pressures are declining. Not anymore. Those days are over, and the Fed will get even harder. The compromises he will face next week may only be the beginning.