ScenariosWe subject the economy to a shock to estimate two counterfactual scenarios where the peak policy rate would otherwise be roughly 5%.
- Liquidity crisis: The first is a shock along the lines of the one affecting the economy and does not materially deteriorate or abate until the end of the second quarter. While credit risk and pervasive uncertainty remain, recent policy steps are sufficient to prevent the liquidity crisis from transforming into an economy-wide credit crunch. This implies that the Fed is well positioned to hike the policy rate by 25 basis points or could choose to pause with the knowledge that the proxy rate would climb to somewhere between 5% and 5.25%. The consumer price index under this scenario would return to near the Fed’s 2% inflation target by the end of next year.
- Credit crunch: In our alternative to the baseline, the crisis intensifies with more bank failures and bank seizures, causing extreme volatility across asset classes, hurting systemically important financial institutions and resulting in a credit crunch that would lead to an increase of 150 basis points in the policy rate. Under this scenario, inflation would return to a rate below the 2% target to roughly 1.8% by the end of next year.