The respective headquarters of the Fed and the ECB. (Photo credits: Federal Reserve ECB)
Central banks are realizing the price of a total brake on monetary policy. The pitfalls of the “separation principle”: the big gap between financial stability and price stability. Finesse is required in the allocation of portfolios.
Central banks are keen to stay the course in the fight once morest inflation, which is creating cracks, especially in the banking sector. We have recently seen turbulence in the US around Silicon Valley Bank, followed by the takeover of Credit Suisse by UBS and speculative disruption here as well. In recent days, calm has returned. The markets are in the process of making up their minds and digesting the current situation. It is a question of not rekindling the trauma of the great financial crisis of 2008. The banking sector in particular, where money is at stake and where confidence is therefore essential, is going through tumultuous times. Market jitters are felt in every nook and cranny.
In the space of barely a year, the majority of central banks, led by the Fed, have entered into a restrictive interest rate environment. Central banks are unlikely to stop doing so as long as inflation rates are too high and no serious disruption to growth and employment is seen.
At the same time, central banks face a longer-term problem, as the restart following the Covid pandemic has brought inflation back. Unlike in previous decades, expansive monetary policy therefore has visible side effects. And as the labor force becomes scarcer with changing demographics, the energy transition puts pressure on prices and production costs rise due to the reorientation of supply chains, inflation might remain structurally high. The dilemma for central banks is to adapt their monetary policy to this post-covid reality of structurally higher inflation.
So far, their reaction in this situation has been to step on the brakes. The current rise in interest rates has been the fastest and steepest since 1980. Right now we are already seeing the housing market slow down, but consumers are still spending. They have saved huge sums of money during the coronavirus crisis and continue to spend it.
At the same time, such a large monetary brake almost necessarily causes stress in the financial system. The collapse of the ASR is an almost direct consequence of the actions taken by central banks, in particular the sharp rise in interest rates. The concrete problem there has certainly been solved by the Bank Term Funding Program (BTFP), but the loss of confidence linked to the crisis should have negative repercussions on the supply of credit to the industry. The problem of confidence is also felt in Europe, given the turbulence around several major banks.
Central banks between the fight once morest inflation and financial stability
Faced with the turmoil in the banking sector, will central banks stop raising short-term interest rates? It’s unlikely. They are fighting once morest inflation that is still too high. Two weeks ago, the ECB took the lead in raising its interest rate by 25 basis points. Last week, the US Federal Reserve (Fed) and the Bank of England (BoE) followed with 25 basis points each. The SNB raised its key rate by 50 basis points. At the Fed’s press conference last week, its chairman, Mr. Powell, tried to suggest that the Fed was managing to balance difficult inflation conditions, a strong labor market and a system bank sector largely undermined by a rapid rise in interest rates.
The so-called “principle of separation” suggests that central banks have the tools that allow them on the one hand to maintain financial market stability through sufficient liquidity and on the other to preserve price stability by increasing interest rate. But is this separation credible?
In addition to raising the policy rate by 25 basis points last week, the Fed has effectively kept liquidity in the system (it has so far expanded its balance sheet by nearly $300 billion in March), while leaving unchanged its estimate of the key rate for the end of the year at 5.1%.
Additionally, Fed Chairman Powell hinted that the Fed was nearing the end of the rate hike cycle. We therefore realize that the time may have come to integrate the restrictive interest rates into the system with the long expected variable delay. According to Powell at the press conference, the tensions seen in recent weeks in the financial system alone should replace, by their restrictive effect, a further rise in interest rates. Possibly even several. What it means: The much-talked-regarding separation between monetary policy and financial stability is an illusion.
