The aftermath of First Republic Bank’s rescue by JPMorgan Chase has prompted leading U.S. economists to forecast a sustained period of higher interest rates.
These elevated rates could reveal additional vulnerabilities in the banking sector, potentially affecting central banks’ abilities to manage inflation effectively.
The U.S. Federal Reserve is set to announce its latest monetary policy decision on May 3, with the European Central Bank following suit on May 4.
Central banks worldwide have been aggressively raising interest rates for over a year in an attempt to control soaring inflation. However, recent warnings from economists suggest that price pressures are likely to remain elevated for an extended period.
Inflationary Concerns Dominate U.S. Economic Outlook
The World Economic Forum (WEF) Chief Economists Outlook report, published on Monday, emphasized that inflation remains a primary concern.
Almost 80% of the chief economists surveyed believe that central banks face a trade-off between managing inflation and maintaining financial sector stability. A similar proportion of economists anticipates that central banks will struggle to achieve their inflation targets.
Saadia Zahidi, WEF Managing Director, explained that central banks will need to carefully balance their efforts to reduce inflation further while addressing financial stability concerns.
About three-quarters of the economists surveyed expect inflation to remain high or central banks to be unable to act quickly enough to reduce it to target levels.
Ripple Effects of Bank Failures
First Republic Bank became the latest casualty among mid-sized U.S. banks, following the sudden collapse of Silicon Valley Bank and Signature Bank in early March.
JPMorgan Chase intervened, acquiring nearly all of First Republic’s deposits and a majority of its assets after the California Department of Financial Protection and Innovation seized the bank.
Despite JPMorgan Chase CEO Jamie Dimon’s assertion that the resolution marked the end of recent market turbulence, several leading economists at the World Economic Forum Growth Summit in Geneva on Tuesday warned that higher inflation and increased financial instability are here to stay.
Structural Changes Contribute to Inflationary Environment
Karen Harris, managing director of macro trends at Bain & Company, highlighted that we have entered a new era characterized by structural inflation, more trade barriers, an aging demographic, and a declining workforce.
These factors, she explained, necessitate investment in automation and lead to reduced capital generation, fewer capital and goods movements, and increased capital demands. Consequently, inflationary pressures will be higher.
Harris emphasized that this does not mean actual inflation figures will be higher but that real rates, which are adjusted for inflation, will need to be higher for longer.
This situation creates significant risk, as the shift to higher rates may result in unforeseen failures due to the entrenched calibration to an era of low rates.
Jorge Sicilia, chief economist at BBVA Group, suggested that central banks may adopt a “wait and see” approach after the abrupt rise in rates over the past 15 months. However, he expressed concern over the potential existence of unknown “pockets of instability” in the market.
Sicilia also pointed to the International Monetary Fund’s latest financial stability report, which mentioned the “interconnectedness” of leverage, liquidity, and these pockets of instability.
He argued that although instability is inevitable, it could become much worse down the road if inflation does not decrease to levels close to 2 or 3%, and central banks remain active in their current capacity.
