The central banks and playing with (interest rate) fire

“Who comes next?” – who’s next? That’s the simple question posed by public finance scientist Volker Wieland in Frankfurt. It’s the conference The ECB and Its Watchers. Wieland asks which bank could be the next to stumble, like Silicon Valley Bank or Swiss Credit Suisse.

The large lecture hall of the university is well filled. Many well-known faces from the financial sector will be present. First speaker: ECB President Christine Lagarde. She is obviously trying to explain, to dispel doubts. But in the end, that thwarts her compatriot Voltaire. “Doubt is not a pleasant premise, but certainty is an absurd one.” It goes without saying that this is not a lecture in philosophy. It is the acknowledgment that the future path of interest rates is uncertain. Not least because of the uncertainties in the banking system, whereby the European one is stable and secure.

Who is the next shaky candidate?

In doing so, Lagarde expresses in the morning what her colleague Jerome Powell on the other side of the Atlantic also emphasizes in the evening: “The US banking system is solid and resilient,” he affirms – despite or perhaps because of the bankruptcy of Silicon Valley and Signature Bank. And the unrest in the regional banking sector, where another institution is counted with the First Republican Bank. But no one knows what else may come.

The statements are no coincidence from the top currency watchdogs in the dollar and euro area. Because the current unrest has a cause. And they are the central banks themselves. Because of their strong and determined interest rate hikes in the past year, the prices of current bonds in bank balance sheets have fallen. Those who are currently not dependent on liquidity can sit it out and cash in on the bonds at par on their maturity date. But when customers – like at Silicon Valley Bank – suddenly want their deposits back in large numbers, that’s a problem for some banks.

On the other hand, rising interest rates also have other effects that are definitely desirable. High interest rates make loans more expensive – and weaken demand for them. As a result, spending and investments are falling. And that is exactly the goal. Because the central banks want to get the rampant inflation under control; their key lever is interest rates, which they can use to tighten money, which lowers price pressure.

“Recent developments are likely to result in tighter credit conditions for households and businesses, weighing on economic activity and hiring,” Powell said. He means not only the rising interest rates, but also the uncertainty as a result of the bank failures. “The extent of these effects is uncertain.”

There they are again – the doubts

Christine Lagarde argued in a similar way in Frankfurt on Thursday morning. Corporate and residential construction investments have fallen noticeably in the past three quarters, a consequence of the abrupt reversal of the previous zero interest rate policy. It will be observed closely whether there will be increased “transmission” in the coming months, which means on the one hand the effect of rising interest rates on the real economy. On the other hand, there are also signs that the uncertainty in the banking sector is leading to tighter credit conditions. Then the recent crisis would virtually take over part of the work of the central bank, which is why further increases in interest rates are not a given from the outset.

The ECB is following a solid strategy “that is based on the data and anchors the willingness to act, but does not compromise on our primary goal,” said Lagarde. The primary goal is price stability or inflation of around two percent. Very similarly, Jerome Powell puts it: “The Committee will monitor the incoming information closely and assess the implications for monetary policy.” However, he assumes that an additional tightening of monetary policy could be appropriate in order to bring inflation back to two percent over time.

The central banks on both sides of the Atlantic are now navigating in confusing terrain riddled with fog: On the one hand, high inflation is threatening. On the other hand, the problems in the banking sector and the economic consequences of the steep interest rate path. The compass of a clear forward guidance put them aside. In the recent past, they used this to announce upcoming interest rate hikes in order to keep inflation expectations low. Instead, they emphasize that from now on they want to make decisions based on data or information. This is how they create room for maneuver in navigation. In other words: You drive on sight.