After a long period of unusually low interest rates, some may have been concerned that when central banks hike interest rates rapidly, eventually something could break. Events unfolding in the past seven days have served as a sharp reminder that there may be a trade-off between central banks’ fight against inflation and financial stability. Referring to ECB President Lagarde’s press conference this week, they disagree though.
The ECB hiked interest rates by 50bps and repeated their commitment to hike more. As long as the baseline persists i.e. inflation remains sticky and a systemic crisis is avoided, the ECB has ‘a lot more room to cover‘. The ECB sees no contradiction in sustaining price and financial stability at the same time, which we consider a signal that the threshold not to hike is high. If necessary, new ‘creative’ measures can be introduced to address liquidity issues. We keep our call for a 50bp hike in May and a peak policy rate reached in July of 4%, see Flash ECB Review: 50bp hike but no guidance for May, 16 March.
Last weekend, the US authorities took control over two banks that had ended in an acute liquidity crisis. The response was stark: All deposits in the two banks would be covered and the Fed set up a new term-funding program where banks could access liquidity against high-quality collateral, valued at par. It is unusual for a central bank not to protect itself from credit losses by imposing haircuts on collateral, and by all measures, the response can be considered impactful. Yet, on Thursday, concerns focused on another US bank, First Republic, until it received a USD 30bn deposit from larger lenders. Fears are also reflected in the swelling of Fed’s new lending facility, in a flow of deposits from medium-sized to large US banks and in investors’ flight to money market funds.
Worries regarding banking sector health quickly crossed the Atlantic. In Europe, the SNB was forced to step in and provide a liquidity loan to its second largest bank Credit Suisse on Wednesday evening after the share price had plummeted and the CDS market was pricing in a rising risk of default. By Thursday, the share price had started to recover but the CDS was still trading at distressed levels. Some systemic risk indicators have also risen. For example, expected volatility has increased in the stock market and even more in the bond market. Money market risk premia has increased slightly but remains far from the very distressed levels seen during the global financial crisis.
Despite financial stability concerns, inflation woes persist. In the US, February CPI came in close to our expectations but core surprised to the upside. We keep our call for a 25bp hike by the Fed next week (Global Inflation Watch – Central banks balance inflation and financial stability risks, 15 March). Also, February CPI in Sweden came in higher than expected, and as a result, we changed our Riksbank call and now expect a peak rate at 4.25% (prev. 3.75%) Flash Comment: Riksbank to hike 75bp + 50bp from here, 15 March.
Apart from the obvious market focus on Fed next week, flash PMIs from Europe and the US are likely to attract interest. We pay close attention to whether confidence has been shaken by the recent developments (data has been collected mid-month). We will also follow closely Lagarde’s speech on Tuesday for any change in tone. We expect the Bank of England to deliver their final hike next Thursday, bringing the bank rate to 4.25%.