Central banks hold the line on inflation

Central banks in the US, Eurozone and UK all raised interest rates over the last couple of weeks, despite the substantial stress in financial markets following the collapse of two US banks and the forced purchase of Credit Suisse by UBS.

The ECB was the first to move with a 50bp hike on 16 March, taking the main refinancing rate to 3.5%.  The Federal Reserve and the Bank of England followed last week with 25bp increases to benchmark rates, taking them to 5.0% and 4.25% respectively. The decisions highlighted policymakers’ commitment to bringing inflation back down to target levels of 2%, and also served to show confidence in their banking systems. 

ECB President Christine Lagarde was clear that there was “no trade-off” to be made between price stability and financial stability, and that central banks had the tools to insure the latter while raising rates to achieve the former.

Messaging from the Fed and the Bank of England was a little softer, with Fed Chair Powell acknowledging that the FOMC had considered pausing this month, before deciding that that the banking system was resilient enough for them to raise rates. He stressed that inflation was still too high, and the new economic projections show that the Fed doesn’t expect inflation to get back to 2% until Q4 2025. Nevertheless, the FOMC’s interest rate projections – the dot plot – showed that the Fed is likely close to the end of its hiking cycle, with just one more 25bp rate hike forecast this year.   

The BoE’s monetary policy council was also relatively dovish in their post-meeting statement, saying that the Bank expected inflation to fall “sharply” over the rest of the year, despite the surprise acceleration in UK CPI to 10.4% y/y in February.

The challenge for central banks going forward is threading the needle on inflation and the real economy. The inflation data suggests that more tightening is necessary to cool demand. Inflation figures for February suggest that core inflation, excluding food and energy costs, is very sticky at a high level across developed markets. Eurozone core CPI rose to 5.6% y/y last month, while UK core inflation surged to 6.2% in February from 5.8% in January. US core CPI softened fractionally on an annual basis but remains high at 5.5%.

However the recent instability in the banking sector means that banks – particularly the smaller ones at risk of bank runs – are likely to aggressively tighten their credit standards and cut back on lending. This could have the effect of another one or two interest rate hikes in terms of dampening growth, or end up pushing the economy into recession. Central banks may then not need to hike rates further to bring inflation down. This seems to be what the market is betting on – Fed Funds Futures are pricing at least three 25bp rate cuts by the end of the year in the US. 

While policymakers believe they have ringfenced the troubled banks and provided sufficient liquidity to allow other banks to meet their depositors’ withdrawal requirements, there is a significant amount of uncertainty about the impact this current bout of financial stress will have on the real economy.

The size of the Fed’s balance sheet has grown by USD 400bn over the last two weeks as banks have accessed the liquidity facilities provided by the central bank. However the amount borrowed by banks last week was significantly smaller than in the week to March 15^th, when Silicon Valley Bank and Silvergate were taken over by regulators, indicating that the situation has stabilized for now. It remains to be seen by how much banks curb lending to repair their balance sheets, and the impact that this will have on the real economy and unemployment. 

This article was published in The National on 27 March 2023