The price or/of financial stability

Many countries are experiencing single- to double-digit price inflation with some countries in triple digits (over 100% annually), like Argentina, Zimbabwe, Syria, and Venezuela. These were caused by the pandemic and the Russian invasion of Ukraine that disrupted the supply chain and the monetary pump priming by their central banks to have money easily available to sustain aggregate consumer and business demand. This was considered as the better option to avoid a deeper recession. The world economies were awash in liquidity, but lockdowns slowed “money velocity” so monetary easing didn’t immediately trigger price inflation. The rise in prices came about when the restrictions were lifted and people went back to traveling and shopping, but with the supply chain still disrupted and compounded by the Ukraine war.

The primary mandate of all central banks is “price stability” which means keeping inflation manageable, preferably in single digits, as this secures consumer and business confidence necessary. While inflation cannot be avoided, and is in fact needed to spur investments, hyperinflation makes people lose faith in their currencies, banks, and economy. The end of the pandemic with the Ukraine war still ongoing had the possibility of keeping inflation going higher, as the supply of commodities were low and logistics still disrupted. So, central banks decided to rein in money supply by increasing policy interest rates and open market operations. In doing so aggregate demand falls, there will be less consumption expenditures, lesser borrowing from the banks, and lesser investments, thereby taming rising prices.

The consequences/effects of these monetary corrective measures are well-known but the magnitude of the effects weren’t anticipated. While the fall in the price of bonds and other fixed-rate financial instruments were expected, as their yield are inversely proportional to interest rate movements, the size of the individual banks bond portfolio in relation to the size of the banks became problematic. Writing down the values of their bond holdings to market prices would wipe out the capital of some banks. These happened to two medium-sized US banks (Silicon Valley Bank and Sovereign Bank) and they had to be rescued by bigger banks to avoid contagion to other banks. Credit Suisse, one of the largest banks in the world, had to be absorbed by Union Bank of Switzerland, with the Swiss Central Bank providing the funding but Credit Suisse writing down to zero $20 billion in bond holdings and making it own bonds to junk status. These events have the potential of destabilizing the individual economies of countries and of the world, if people lose their confidence in their financial/banking systems.

So, it seems the corrective action to get back to the main mandate of price stability created another problem of financial instability which is confidence-sapping and an economic downer to consumers and investors. This is the dilemma and it cannot have an either/or solution as both mandates are equally important for a functioning economic system. It needs a balancing act to achieve a degree of success without defeating the main objective of price stability and yet maintaining financial stability. So far this issue has been contained in the US and most European countries have made appropriate actions, but not so well in underdeveloped and developing countries. Venezuela. Argentina, Chile, Turkiye, and some African countries are still in trouble

The Philippines hasn’t been spared this problem, but the smaller sizes of the banks and the many years of restrictive monetary policy and bank regulations minimized the problem. It helped that our monetary technocrats were aware and on top of the situation. The supply side problem of inflation could have been done better by timely actions in the production and importation of critical commodities, but some government officials are incompetent. The price of financial stability should be tolerable inflation and it is the task of governments to achieve both price stability and financial stability. These can only be done by good governance.