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Central Banks and the Looming Financial Reckoning

Across the advanced economies, central banks have rightly prioritized maintaining financial stability and supporting the real economy over fighting inflation with interest-rate hikes. But with financial fragility rife and public and private leverage at all-time highs, their next big test is coming.

NEW YORK – Since early 2020, central banks across the advanced economies have had to choose between pursuing financial stability, low (typically 2%) inflation, or real economic activity. Without exception, they have opted in favor of financial stability, followed by real economic activity, with inflation last.

As a result, the only advanced-economy central bank to raise interest rates since the start of the COVID-19 pandemic has been Norway’s Norges Bank, which lifted its policy rate from zero to 0.25% on September 24. While it has hinted that an additional rate increase is likely in December, and that its policy rate could reach 1.7% toward the end of 2024, that is merely more evidence of monetary policymakers’ extreme reluctance to implement the kind of rate increases that are required to achieve a 2% inflation target consistently.

Central banks’ overwhelming reluctance to pursue interest-rate and balance-sheet policies compatible with their inflation targets should come as no surprise. In the years between the start of the Great Moderation in the mid-1980s and the 2007-08 financial crisis, advanced-economy central banks failed to give sufficient weight to financial stability. A prime example was the Bank of England’s loss of all supervisory and regulatory powers when it was granted operational independence in 1997.

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