Inflation-fighting Fed faces dilemma

Financial crises come unexpectedly.

They spread quickly like dominoes, starting with weak links and resulting in the paralysis of the financial system in an instant. The 2008 global financial crisis began with the subprime mortgage crisis and led to a chain of bankruptcies of world-class investment banks, including Lehman Brothers.

This resulted in credit crunches and asset price declines, causing financial instability, which led to a sharp decline in investment and consumption in advanced countries. It also caused a rapid contraction of trade credit and a decline in exports in developing countries, resulting in a global economic downturn.

Today, we may be on the brink of another crisis. This time, the aggressive interest rate hike by the U.S. Federal Reserve is considered the primary cause of the current U.S. and European banking turmoil. The global inflation that began in early 2022 forced most central banks, including the U.S. Fed, the European Central Bank and the Bank of Korea, to raise interest rates. They are still waging a war against inflation by taking big steps and giant steps, raising their rates by 0.5 percent to 0.75 percent at a time, in order to take back Easy Money.

The rise in benchmark interest rates led to a rise in bond yields, which in turn led to a decline in bond prices held by most commercial and investment banks. This resulted in investment losses that triggered depositor anxiety. Finally, starting with small banks such as Silicon Valley Bank and First Republic Bank, a chain of bank runs occurred.

This in turn amplified concerns about Credit Suisse’s financial credibility, forcing the 167-yearold institution into a merger with UBS. Increasing investment losses during the process of selling assets held by banks is snowballing into a vicious cycle.

One of the main dilemmas that the Fed faces nowadays is how to balance its dual mandate of promoting maximum employment and stable prices, while also dealing with the economic fallout from the COVID-19 pandemic.

Specifically, the Fed is grappling with how to support the economy through monetary policy measures using interest rates and asset purchases, while also preventing inflation from rising too much.

Globally, however, inflation is persisting at high levels and there is no clear evidence that the underlying inflation is trending downwards. Central banks are in a dilemma to bring rates to sufficiently restrictive levels so as to dampen demand. But the recent banking turmoil in the U.S. has put the Fed in an even more difficult situation as it faces mounting pressure to slow down its interest rate hikes.

As for Korea, its central bank recently stated that the chances of contagion of systemic risk arising from turmoil abroad are small since domestic financial institutions have different asset and liability structures from those of Silicon Valley Bank and Credit Suisse.

However, it analyzed that there are concerns that financial market price volatility may increase, credit concerns for some financial institutions may be raised and potential risks for vulnerable sectors may materialize if global financial conditions change rapidly due to this situation.

After the Fed’s rate hike in March, the interest rate difference between Korea and the U.S. has expanded from the existing 1.25 percentage points to 1.5 percentage points, recording the largest inversion since 2000. As a result, there are growing concerns about increasing capital outflows, which call for continuing the rate hikes.

On the other hand, both trade and the current account have shown large deficits since last year due to sluggish exports, which raises a different concern over the possibility of recession or stagflation. In addition, Korea’s large household debt, which stands at over 1,050 trillion won ($804 billion), and the recent deterioration of nonperforming loan rates cast a dark shadow over the country’s economic stability. Accordingly, in the public and private sectors, voices are calling for the Bank of Korea to lower interest rates.

Just like its American counterpart, the Bank of Korea is also in a dilemma over whether to raise or freeze the benchmark rate in its coming April policy meeting.