MNI INTERVIEW: US Bank Stress Not Very Disinflationary-KC Fed

The U.S. regional bank turmoil in March will put a smaller dent on inflation than traditional monetary tightening, Kansas City Fed economist A. Lee Smith told MNI.

His comments are based on new research that cautions against counting on tighter credit conditions to work as a substitute for additional interest rate increases.

"The stress and the banking turmoil we experienced may not be all that disinflationary," Smith said in an interview Friday, before the pre-meeting blackout period began. "Financial stress is really very different than financial conditions."

Historical evidence suggests tighter credit conditions emanating from financial shocks generate only modest disinflationary effects compared to the kind of increase in the unemployment rate that comes from higher official interest rates, according to the recent analysis from Lee and co-authors.

"To the extent you're going to cut off some of that credit and you're going to see less of that expansion from firms, either startups or expansions from existing firms, it has this echoing effect on the economy's productive capacity going forward," Smith said.

ADVERSE SUPPLY EFFECT

"That is going to act very much like an adverse supply effect that will counteract some of the disinflation from just a pure demand shock. These credit shocks can have significant real effects but may not lower inflation all that much," he added. (See MNI POLICY: Fed Most Divided Since Start Of Hikes, More Loom)

The analysis by Smith, Brent Bundick and Johannes Matschke shows that financial stress is about half as disinflationary as Federal Reserve monetary tightening. A one standard deviation increase in financial stress measured by the Kansas City Fed’s Financial Stress Index typically portends an increase in the unemployment rate of 0.7ppts and a fall in CPI by about 0.4ppts in the first year, compared to 0.65ppts following monetary tightening, the analysis shows.

Some Fed policymakers have argued that the credit stresses and banking issues in March might dampen inflation like monetary policy tightening, perhaps reducing the need for additional rate hikes.

"We're arguing that that may not be the case and certainly historical evidence cautions against that interpretation," said Smith, though he declined to comment on the current rate outlook.

That is because of a persistently lower path of investment spending following a financial stress episode could adversely affect the economy’s future productive capacity.

"The fact that investment is more responsive for a similar size movement in the unemployment rate, and we see a bigger fall in investment, it's an indication to us that there's this credit supply effect that transmits to the economy in a way that reduces the ability in the economy to produce in the future," he said.

"The March episode could affect not just the pricing of credit, but really the provision, the flows and the quantities of credit."