How Front-Loading Rate Hikes Risks Financial Instability

The heated debate about how central banks should respond to high and persistent inflation has focused primarily on how high interest rates should go and how long should they stay there. A third issue, that of front-loading the increases, is particularly relevant in this rate cycle. After all, central banks are seeking not just to lower inflation without unduly damaging growth and jobs; they also face the challenge of steering a fragile financial system in which a market malfunction can significantly damage economic well-being.

Consider the Federal Reserve. Having badly misdiagnosed inflation last year and fallen behind its price-stability mandate, the central bank significantly intensified its policy response over the last few months. The June rate increase of 75 basis points was the first of that size in 28 years, and the Fed has followed with two similar increases, a record, with a third one expected at its meeting next week.

This Fed rate-increase cycle, which has already delivered a total of 3 percentage points in just over six months, is the most front-loaded one in a long time. The cooling housing market, the sharp appreciation of the dollar and the headaches caused for many countries worldwide are examples of its effects.

Yet reflecting how tardy the Fed response has been, the financial markets are pricing in an additional 1.75 to 2 percentage points of rate increases for this cycle. Drawing on Chair Jerome Powell’s repeated references to Paul Volcker, the 1980s central banker famous for crushing inflation, quite a few expect high rates to persist for a while.