“Fix the roof while the sun is shining.” This often-repeated advice from Christine Lagarde, then managing director of the International Monetary Fund, wasn’t heeded by enough policymakers in the years before the current rise in Russia-Ukraine tensions. Now, the global economy has less policy flexibility to deal with a possible stagflationary shock, and central banks have few good options to counter possible financial market malfunction that would amplify economic challenges.
The Federal Reserve, the world’s most powerful central bank, is a leading example of this syndrome of limited policy flexibility. Having missed multiple windows for orderly normalization, it finds itself in the midst of rising geopolitical strains with already very low interest rates and a bloated balance sheet. Making things more challenging, the Fed has eroded its inflation credibility and lost control of the monetary policy narrative.
This is a most unfortunate situation in the face of a possible stagflationary shock that would weaken global growth and give another impetus to inflation should a more significant armed conflict erupt between Russia and Ukraine — one that would likely lead to a spike in prices of energy and some other commodities, a proliferation of economic and financial sanctions, and a decline in both household and business confidence. It would be even worse if the functioning of financial markets were to be stressed — regrettably, a material risk for at least three important reasons:
- First, conditioned by massive and predictable injections of liquidity, risk-taking has been significant, with quite a few investors venturing far and wide in search of higher returns.
- Second, the last decade has witnessed a growing imbalance between the increasing size and diversity of asset holders and the reduced ability of the system to accommodate a sudden generalized shift in the markets’ conventional wisdom.
- Third, the QE-induced shift of “safe assets” from markets to central bank balance sheets has limited investors’ ability to “self-insure” in a timely fashion.
