Can central banks maintain financial stability and continue their battle against inflation? Over the next few months, we are going to find out.
In theory, central banks have separate tools for monetary policy (interest rates and quantitative easing/tightening) and financial stability (liquidity interventions and countercyclical capital buffers), meaning they don’t face a trade-off between monetary and financial stability targets.
But the turmoil triggered by the collapse of Silicon Valley Bank (SVB) and the sale of Credit Suisse (US:CS) to fellow Swiss giant UBS (US:UBS) has seen market expectations for interest rates plummet as traders question how much further central banks will increase rates in the face of growing financial stability concerns. Since 10 March, expectations for the year-end Fed Funds rate have fallen by 150 bps and almost 65 bps have been knocked off expectations for the year-end bank rate in the UK. Investors in bank stocks did at least see a rebound on Monday after the Credit Suisse deal had initially knocked UK banks by 3-5 per cent.
Simon French, chief economist at Panmure Gordon, said that the market does not believe central banks can separate their inflation and financial stability targets, adding that “the reality is there is no such neatness in the eyes of capital markets”.
Despite the tensions, the European Central Bank (ECB) pushed ahead with a 50 basis point rate hike last week as president Christine Lagarde stressed that inflation was “projected to remain too high for too long”. The US Federal Reserve and the Bank of England will publish their own decisions on Wednesday and Thursday respectively against a backdrop of persistent inflation. UK inflation re-accelerated last month, rising from 10.1 to 10.4 per cent.
Berenberg senior economist Kallum Pickering said the inflation surprise complicated matters for the BoE. "The decision will hinge on whether policymakers believe the backward looking inflation surprise is likely to be the start of a trend or whether it is a one-off linked to normal monthly volatility," he said.
Vicky Redwood, senior economic adviser at Capital Economics, said the ECB’s example showed that “having separate tools to provide liquidity to institutions leaves central banks free to use interest rates to control inflation”. In a liquidity crisis, central banks can act as a lender of last resort, ensuring that institutions can meet their short-term obligations.
At the same time, markets could be underestimating policymakers’ determination to continue with interest rate hikes.
A poll of economists conducted by the Financial Times between 15 and 17 March revealed far more aggressive expectations for the future path for rates. Although market pricing puts peak US interest rates just below 5 per cent, almost half of the economists surveyed expected the policy rate to peak between 5.5 and 6 per cent. The target rate is currently 4.5-4.75 per cent.
There is also the possibility that the current turmoil slows inflation itself. Economists at Goldman Sachs said that “the banking crisis could have disinflationary effects”, and estimated that tighter lending standards could have an impact equivalent to 25-50 bps of Fed rate hikes.
Gilles Moec, group chief economist at AXA Investment Managers, noted that “down the line, persistent stress in banks can affect growth and inflation to the point that monetary policy needs to be recalibrated”.
But for now, central bankers face a more immediate concern. Moec said that policymakers need to balance “the already tangible signals that inflation is taking too much time to decelerate with the mere possibility that the banking stress triggers a steep deterioration in economic activity and hence dampens inflationary pressure”.
What is the difference between a liquidity and solvency crisis?
