MNI INTERVIEW: Financial Stability At Risk As ECB, Fed Hike

Rising interest rates will put parts of the global financial system under severe strain, posing a serious dilemma for the European Central Bank and the Federal Reserve as they try to contain inflation, one of Germany’s foremost economists told MNI.

Financial stability risks could emerge “very quickly” for both the ECB and the Fed, putting them “in a similar situation as the Bank of England was: namely, having to choose between fighting inflation and safeguarding financial stability,” said Moritz Schularick, macroeconomics professor at Sciences Po and the University of Bonn, and this year’s Leibniz Prize winner. Central bank independence is also likely to come under pressure as government financing costs rise, he noted.

“There's an effective upper bound on interest rates, a financial stability upper bound,” Schularick said shortly before ECB policymakers made their second consecutive 75bps rate hike last Thursday, putting the deposit rate on course for 2% in December.

“It will be extraordinary if after a five-sigma move in interest rates over such a short period - after 10 years of very low interest rates - there isn't a substantial pocket of the financial system that is exposed to interest rate risk, and will be in deep trouble,” he said. “Is that when the Fed hits 5%? Is it when the ECB is at two-and-a-half or 3%? I don't know. But it's definitely out there.” (See MNI INSIGHT: Fed Sees Fin. Stability As Separate From Rates)

INDEPENDENCE UNDER THREAT

As government pressure on central banks builds, the ECB’s multinational structure leaves it relatively well positioned to push back, he said.

“Nineteen individual countries would have to coordinate to put pressure on the ECB to monetise deficits. The risk of having some form of fiscal dominance is much greater in places like the UK or the U.S., where you have one single, unitary government.”

But dual pandemic and energy price shocks will pose a significant challenge to central bank credibility, said Schularick, coauthor with economists Martin Kornejew and Paul Schmelzing, and historian Niall Ferguson, of a soon-to-be-published paper on 400 years of central bank balance sheets.

“In these emergency situations there are inflationary episodes, and it's well understood that this is also part of what asset holders are compensated for with risk premia, and bondholders are taxed in wars or after wars,” he said, “In itself this is not a big risk for the credibility of the monetary framework, but the short succession of two big shocks could be.”

GERMAN INFLATION

For the moment, though, there are no signs of a wage-price spiral in the eurozone’s biggest economy, Germany.

“I’ve seen no indication that demands are forward-looking. Even if we get increases of 10% this year, as long as we don’t get another 10% the year after there will be no wage-price spiral,” he said.

But, while gas supplies will be tight over the winter, the situation should be manageable, with storage likely to still be at around 55% capacity in April-May, before prices drop sharply.

“Industry captains have even said in recent weeks, ‘If you tell us the gas prices are going to be double what they were, that's okay. What kills us more is the uncertainty, rather than the price, per se,’” he said.

But Germany must diversify away from over-reliance on China, with the green transition and not exports, likely to become the main engine for growth, even with a cheap euro, said Schularick. The federal government should act more boldly to create private sector incentives for a more sustainable economy, moving away from its “piecemeal, anxious” legislative approach, and its propensity to coordinate with industry groups and trade unions.

Successive German governments’ failure to get sometimes contentious green legislation past the country’s 16 semi-autonomous states offers a salutory lesson as to how similar debates might replay in Brussels, he said.

“A lot of these questions - energy markets, energy infrastructure, defence - absolutely need a European perspective. But we also see that we can't even agree on the national level. So as much as I would like to do it on a European level on the energy side, I would not stand in the way of progress on a national level.”