Priority test: Can officials fight inflation and buoy banks?

As banking turmoil ripples around the world, government officials in many nations are suddenly confronting a two-pronged problem: how to fight inflation with one hand while bolstering financial system stability with the other.

These tasks are hard enough on their own. Added difficulty stems from the fact that typical solutions for them can work at cross-purposes. Raising interest rates to fight inflation can slam banks in some circumstances. Keeping rates low may calm financial institutions but fuel the fire of rising prices.

Why We Wrote This

How can officials both tame inflation and ensure bank stability? It’s a difficult balance that for now, at least, appears to still include interest rate hikes.

That’s left regulators from Frankfurt to Washington facing a clash of values. Is one of these problems worse than another? Must they be fought separately?

To this point one thing seems clear: Central banks are reluctant to roll back anti-inflation measures, as prices haven’t been tamed as much as they would like. On Thursday, the European Central Bank announced it was going ahead with a half-point interest rate increase.

If the bank had canceled the hike, it might have signaled to the markets that the banking system is in worse trouble than it seems, says Jon Danielsson at the London School of Economics.

“The best way not to panic the markets is to go ahead with an interest rate increase that had already been expected by everybody,” he says.
Next week, the U.S. Federal Reserve must do its own weighing of the balance when it meets to decide whether to raise interest rates yet again.

As banking turmoil ripples around the world, government officials in many nations are suddenly confronting a two-pronged problem: how to fight inflation with one hand while bolstering financial system stability with the other.

These tasks are hard enough on their own. Added difficulty stems from the fact that typical solutions for them can work at cross-purposes. Raising interest rates to fight inflation can slam banks in some circumstances. Keeping rates low may calm financial institutions but fuel the fire of rising prices.

That’s left regulators from Frankfurt to Washington facing a clash of values. Is one of these problems worse than another? Must they be fought separately? Can they be addressed together?

Why We Wrote This

How can officials both tame inflation and ensure bank stability? It’s a difficult balance that for now, at least, appears to still include interest rate hikes.

To this point one thing seems clear: Central banks are reluctant to roll back anti-inflation measures, as prices haven’t been tamed as much as they would like. On Thursday the European Central Bank announced it was going ahead with a half-point interest rate increase. U.S. Secretary of the Treasury Janet Yellen, appearing before the Senate Finance Committee, said the American banking system remains sound.

Recent bank failures may have made it more difficult for the U.S. Federal Reserve to raise rates, says Dave Schabes, a University of Chicago Harris School of Public Policy expert on banking and finance. But currently the Fed seems determined to forge ahead.