Macroeconomics continues to argue the connection between growing inflation and economic expansion. The traditional "neutrality of money" theory holds that because inflation affects both prices and salaries similarly and only modifies units of measurement, it has minimal impact on actual gross domestic product (GDP). A related argument is that slowing economic development is not caused by rising inflation but is merely a symptom of fundamental economic issues, such as supply-side disruptions or fiscal imbalances.
As an alternative, certain macroeconomic theories, such as New Keynesian theories, contend that rising inflation can, at least in some circumstances, enhance real GDP in the near run. Such theories struggle to explain "stagflation," which is the phenomenon of simultaneous high inflation and weak growth.
Role of Asset-Liability Mismatch
Our study focuses on an asset-liability mismatch to inflation, a significant friction within the banking industry. Asset-liability mismatch can reduce bank equity and net interest margins amid growing inflation, which will reduce lending to individuals and businesses. The asset-liability mismatch between each bank's balance sheet and growing inflation is calculated in our research. Our metric goes beyond just measuring interest rate sensitivity. Higher inflation expectations continue to impact banks' balance sheets and cash flows, even without tighter monetary policy or higher policy rates. As a result, the market repricing of nominal lending rates, deposit rates, and long-term bond yields occurs.
Initial Evidence
We discover two preliminary results that are consistent with our theory regarding the contractionary impact of rising inflation on bank lending. First, we discover that increases in inflation are associated with upcoming short-term drops in a country's total bank credit-to-GDP ratio by studying a country-level dataset comprising 47 industrialized and emerging nations since 1870 (see Figure 1). Second, lending contraction occurs primarily among the banks most exposed to inflation, as measured by our bank-level inflation exposure measure. Examples of these episodes include episodes in emerging economies in recent decades and Germany's hyperinflation in the 1920s.
Establishing Causality
In order to establish a cause-and-effect relationship between the rise in inflation and the decline in lending capacity within the banking sector, we investigate a natural experiment that occurred in the United States during early 1977. During this period, the inflation rate underwent a one-time increase from 5% to 7%, and subsequently remained stable for the following year, before experiencing a much more rapid increase starting in mid-1978. This natural experiment takes advantage of random variations in reserve requirements for Federal Reserve non-member banks across different states during the 1970s. Non-member banks are state-chartered banks that adhere to reserve requirements set by their respective state regulators. Since reserve requirements primarily entail maintaining a minimum ratio of non-interest-bearing cash to demand deposits, we demonstrate that higher reserve requirements significantly heighten the exposure of non-member banks to inflation. This is due to the fact that the real value of non-interest-bearing cash diminishes when inflation unexpectedly rises.
As non-member banks have diverse reserve requirements based on their location, variations in inflation exposure arise. In contrast, member banks operate under uniform reserve requirements throughout all states, which are established at the national level by the Federal Reserve. Consequently, member banks serve as a control group, as we do not anticipate observing systematic discrepancies in inflation exposure across different states.
To analyse this natural experiment, we employ a two-stage instrumental variables framework. In the first stage, we demonstrate that non-member banks with higher reserve requirements at the state level exhibit greater inflation exposure, as indicated by our bank-level measurement of inflation asset-liability mismatch. Conversely, for member banks (the control group), we observe no discernible impact on inflation exposure. Moving to the second stage of our analysis, we discover that banks with the highest inflation exposure experience the most significant reduction in lending following the inflation increase. We estimate that overall loan growth in the United States decreased by 3.2 percentage points due to elevated inflation, in comparison to the average loan growth of 19% in 1977.
Implications for the Broader Economy
We discover that banks with high inflation risk predominantly cut back on residential mortgage lending, which impacts employment in the construction industry and house price growth in impacted states (see Figure 2). Other employment sectors do not have these effects. Our findings support a substantial body of literature showing that banking channels frequently have significant effects on construction employment and housing, showing that the housing industry is predominantly affected by the contraction of credit supply brought on by inflation.
Conclusion
As a result, our study shows that unexpected inflation spikes frequently cause the banking industry to contract. Banks vulnerable to inflation react by curtailing lending, which affects home prices and employment in the building industry. More generally, these findings point to why rising inflation can result in financial instability, especially when it does so quickly and without warning.
Our examination of historical and global inflation events further emphasizes the importance of banking channels in comprehending the effects of inflation globally. Our research helps to better understand the macroeconomic consequences of inflation and its effects on the banking sector by throwing light on the relationship between inflation and economic growth.
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