Price stability and financial stability are usually distinct and often complementary goals, but they can come into tension at times, said Minneapolis Fed President Neel Kashkari on Wednesday at a National Bureau of Economic Research panel discussion.
Those tensions arose in March when some U.S. banks ran into trouble “due to securities losses triggered by poor risk management by these firms in the context of policymakers having raised interest rates to combat high inflation,” he said. Such tensions “could emerge again,” he said. Inflation will be a prime determinant.
If inflation falls, as markets currently expect, allowing policy rates to decline, “bank balance sheet pressures would likely reduce as longer-term rates fall, causing asset prices to climb,” he said.
However, if inflation proves more stubborn than expected, “policy rates might need to go higher, which could further reduce asset prices, increasing pressure on banks,” Kashkari said. “In such a scenario, policymakers could be forced to choose between aggressively fighting inflation or supporting banking stability.”
He stressed the importance of increasing bank resilience now to lower the odds that tensions will re-emerge, “because banks would be positioned to handle further mark-to-market losses that would stem from higher policy rates.” That would minimize the risk that policymakers would have to choose between bringing inflation down or maintaining financial stability.
Banks aren’t likely to do this on their own, he added. “The historical record shows that banks are unlikely to take meaningful actions to enhance their resiliency against this risk on their own, so bank supervisors should use their existing authority to ensure all banks are prepared to withstand a higher-rate environment,” he said.
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