Monetary blundering making Ukraine tensions worse

“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 policy makers 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.

The risk of disruptions to the smooth functioning of financial markets is not accompanied by Fed policy flexibility to act. Rates are still floored at zero and the ever-growing balance sheet is already near $9 trillion. As all this coincides with worrisome inflation numbers, be it 7.5% for CPI or 9.7% for PPI. The Fed must also worry about its damaged inflation-fighting credibility.

Lacking proper guidance from the Fed, Wall Street has sprinted to call for, and price, a growing number of interest rate hikes this year. Some have urged for these to be front-loaded. A few have gone as far as to advocate an emergency intra-meeting interest rate increase.

Regrettably, this unfortunate policy context is of the Fed’s own making, both short – and longer-term. Just within the last 12 months, for example, it mistakenly downplayed the severity and persistence of inflation. When the central bank finally acknowledged the need to “retire” its “transitory” inflation call – a gross mischaracterization – it hardly adjusted its policy stance to counter the risk of a de-anchoring of inflationary expectations.

This has weakened its policy reputation and involved the Fed missing one opportunity after another to rebuild resilience. As such, the central bank’s limited tools to counter market malfunction also involve a heightened risk of collateral damage and unintended circumstances. The alternative, of relying on government measures, is far from reassuring given the extent of policy polarization.