Governors weigh trade-offs between inflation and financial stability

Governors of central banks from Latin America and the Eurosystem stressed independence is key to bring inflation back to targets while preserving financial stability, in remarks at a recent event.

Additionally, the officials pointed out sustainable fiscal policies and structural reforms to boost competitiveness are required to maintain stable macroeconomic conditions.

During a panel organised by the Central Bank of Brazil, Bank of Spain governor and Basel Committee chair Pablo Hernandez de Cos said “domestic economic policies need to be framed within a culture of stability”. He emphasised international co-operation could help align domestic financial policies with international agreements and international standards.

European Central Bank president Christine Lagarde pointed out the adoption of Basel III rules at major eurozone banks has reduced the trade-off between fighting above-target inflation and preserving financial stability.

Lagarde acknowledged financial instability remains a real threat. Still, “to relax the fight against inflation in order to head off possible risks to the financial sector would be inconsistent with our mandate”, she added. “Worse still, it would amount to financial dominance and lead to a loss of trust in the central bank, which itself can induce financial instability.”

The ECB president explained the ECB’s policy toolkits have evolved considerably since the great financial crisis, allowing greater room to balance both risks. “We can set the appropriate policy stance to control inflation, and at the same time, use other instruments to address risks to financial stability,” said Lagarde.

These include longer-term refinancing operations, offering banks access to liquidity to boost their lending operations, and asset purchase programmes.

Following the collapse of Silicon Valley Bank in the US, the Central Bank of Brazil’s governor, Roberto Campos Neto, highlighted some new elements.

“The cost of transferring money, the marginal cost of transferring money, is going to zero,” he said. Additionally: “We’re seeing that people are transferring money not from one bank to another, but from banks to either non-banks or funds. Two-thirds of funds followed this direction in the recent US crisis.”

Furthermore, Campos Neto stressed recent bank runs have been driven by young people active on social media. “It was very fast,” he said.

The official said regulators and supervisors need to extract lessons from these episodes. “One is that you can have a collective bank run” because consumers can transfer funds out of the banking system.

The second aspect is disclosure. “Now, you can have a company going down, and people associate that company with one bank,” said Campos Neto. “In that context, you could have a bank run fuelled by people talking about the episode on social media.”

Fiscal dominance vs independence

Participants noted that beyond financial stability risks, their institutions have historically faced governmental pressure to abandon the fight against high inflation in order to protect public finances from higher interest rates.

“This is the case of Argentina, for example, having fiscal dominance,” said Julio Velarde, governor of the Central Reserve Bank of Peru. “This is the reason for their inability to preserve the central bank’s independence. That is no longer the case for most countries in the region, but it has been the story of Latin America.”

Although in Colombia the Central Bank of the Republic has been able to freely tackle high inflation, the price level increased year on year by 12.8% in April. The central bank has increased rates from 1.75% in September 2021 to 13.25% now.

Despite the lack of overt political pressure, the government’s fiscal policies are a growing concern for the central bank. In fact, “the depreciation of the Colombian peso during the last two years was one of the highest among Latin American countries and went hand in hand with the deterioration of investors’ risk perception”, said governor Leonardo Villar.

Although the currency has recovered some of the ground lost in the last few months it is still depreciating against other Latin American currencies. “High volatility is probably associated with the uncertainty generated by some economic reforms announced by the government,” added Villar.

The Colombian governor said the role of the inflation target has been affected by the long period in which the central bank expects inflation to be over the target. An increase in the minimum wage well above headline inflation both in 2022 and 2023 has added pressures on costs. Additionally, Villar said indexation has played an important role in Colombia in setting housing rent, public utility fees and prices for very significant groups of services.

Velarde struck a positive note, highlighting how resilient the current monetary policy framework has become in the continent. “Probably it took a little too long for the central banks, especially those in advanced economies, to react” to high inflation, he added, suggesting this was probably due to the long period of low inflation preceding the pandemic.

“Such a long period of low inflation has some advantages. For example, inflation expectations remain well anchored over the two, three-years‘ horizon. That would not have been the case 20 years ago,” said Velarde.

Hernandez de Cos said formal or legal independence “is not enough”. Independence must effectively translate into practical autonomy, a state in which “the staff is the right one, the rules that define independence are also the right ones”, said the official.

“Independence, to be effective, must rest on a rules-based legal and institutional framework. All these relevant dimensions must be recognised, namely at the institutional level distributional, but also at the functional, personnel and financial levels.”