Rising Rates May Trigger Financial Instability, Complicating Fight Against Inflation

Banking systems are largely insulated from inflation, but vulnerabilities at some banks could lead to tradeoffs between containing inflation and protecting financial stability

by Katharina Bergant, Mai Hakamada, Divya Kirti, Rui C. Mano
IMF

Before the pandemic, investors worried about how persistently low inflation and interest rates would crimp bank profits. Paradoxically, they also worried about bank profitability when post-COVID reopening sent inflation and central bank interest rates soaring. The failure of Silicon Valley Bank and other US lenders in early 2023 appeared to validate these fears.

Our new research on the relationship between inflation and bank profitability helps us make sense of these concerns. Most banks are largely insulated from shifts in inflation—the exposure of income and expenses tend to offset each other. Yet some have significant inflation exposures, which may lead to financial instability if concentrated losses lead to wider panics in the banking sector. As several major central banks are reassessing their monetary policy frameworks in the aftermath of the post-pandemic inflation surge, a deeper understanding of the links between inflation and bank profitability can help design better monetary policy frameworks.

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