For the past year, central banks including the Bank of Canada have fought to get inflation under control with single-minded determination. Over the past week, they’ve added a second task: stopping contagion from spreading through the global financial system after the collapse of Silicon Valley Bank and the emergency takeover of Credit Suisse.
These two roles will be in conflict in the coming days, with the U.S. Federal Reserve and the Bank of England scheduled to announce interest-rate decisions on Wednesday and Thursday respectively.
Inflation remains worryingly high, arguing in favour of additional monetary policy tightening. But interest-rate hikes could spook an already skittish banking system, particularly as the problems at U.S. regional banks and at Credit Suisse were caused, to a significant degree, by the historic pace of rate increases over the past 12 months.
The annual rate of consumer price index inflation in the U.S. stood at 6 per cent in February, three times the Fed’s target. Inflation was running at 5.9 per cent in Canada in January. Statistics Canada will publish February inflation data on Tuesday.
The situation is fast-moving and complex. Financial system instability could easily bleed into the broader economy if banks get nervous and pull back on lending, or if wholesale funding markets freeze up, as happened during the 2007-2008 financial crisis and again in March, 2020, at the outbreak of the COVID-19 pandemic.
Tighter lending conditions would help central bankers in the U.S. and elsewhere in their attempt to slow the economy to bring inflation back under control. But their purported goal has always been a “soft landing” for the economy, where inflation comes down without a major economic contraction. They’re not aiming for a juddering halt brought on by a financial crisis.
“A shock like this is negative for growth, there’s no question about that,” said Jean-François Perrault, chief economist at Bank of Nova Scotia.
“But there’s a question of how negative it is. Does this tilt you into a hard landing? Does it make a soft landing less likely? ... It depends on how policy makers are able to ring-fence the current problems.”
Containing the spread of financial contagion has moved to the forefront over the past week, with central bankers assuming their traditional role as lenders of last resort.
After Silicon Valley Bank failed on March 10, the Fed announced a US$25-billion funding facility, allowing smaller U.S. banks to swap their illiquid assets for cash in the event of a bank run. It also pumped liquidity into the U.S. financial system through its discount window, loaning banks a record US$154-billion last week, up from less than US$5-billion the preceding week and exceeding levels seen in the 2008 crisis.
Meanwhile, the Swiss National Bank offered up to 50-billion Swiss francs ($74-billion) in emergency credit to Credit Suisse last week, keeping it afloat until it was taken over by UBS Group over the weekend.
As of last Wednesday, the Bank of Canada has not had to offer any emergency liquidity to Canadian financial institutions, according to the latest data published Friday.
On Sunday, six central banks, including the Bank of Canada and the Fed, stepped up efforts to keep U.S. dollars flowing through the financial system by enhancing their currency swap lines.
These allow central banks to trade their own currency with one another, giving non-U.S. financial institutions access to U.S. dollars in the event of a sudden liquidity crunch. The six central banks said Sunday that these dollar auctions would be available on a daily, rather than weekly, basis – something last done in the early days of the COVID-19 pandemic.
“I think what the central banks are doing is building on the lessons of the last crisis, which is, you’re better off acting and pre-empting things than cleaning them up,” Mr. Perrault said of the rapid-fire moves by central bankers.
Brian Madden: Silicon Valley Bank collapse shows Canada’s concentrated banking sector is a good thing
It’s hard to exaggerate how much things have changed for monetary policy makers in the past two weeks.
Three days before Silicon Valley Bank failed, Fed Chair Jerome Powell told a congressional committee that the fight against inflation was far from over, and that interest rates would likely need to keep rising quickly and to a higher level than previously thought. Markets started betting on a half-point move on March 22, and several more rate hikes after that.
By the start of this week, markets were split roughly 50-50 on whether the Fed will hold interest rates steady or increase them by a quarter-percentage-point on Wednesday, according to Refinitiv data. Even more striking: Interest-rate swap markets are pricing in rate cuts by the Fed beginning this summer.
This shift in market expectations about the trajectory of interest rates caused a dramatic repricing in bond markets, with yields on two-year U.S. Treasury bonds a full percentage point lower than they were on the eve of the Silicon Valley Bank debacle.
Beata Caranci, chief economist at Toronto-Dominion Bank, said that markets may be overreacting.
“In order to get 100 basis points [of rate cuts] this year, you’d be probably forecasting a harder landing than people are talking about for the economy, a deeper recession,” Ms. Caranci said. “Because there is still a very serious inflation risk coming through the U.S. economy, and that’s going to take time to unwind.”
Still, there is little chance that the U.S. or Canadian economy will skate through the current banking sector upheavals unscathed. Former Bank of Canada governor Stephen Poloz said that once bankers and policy makers start worrying about “financial conditions,” you’ve moved past the normal impacts of monetary policy tightening.
“If the Fed is raising rates and the stock market keeps rising then it is said that financial conditions remain accommodative,” Mr. Poloz wrote in an e-mail. “Well that certainly is not the case when you have banking sector turmoil – stocks are down and spreads are widening so credit conditions have turned quite restrictive; this is an additional effect on the economy.
“Also, there is the matter of consumer and business confidence – confidence is dented when something like this happens. This too can be thought of as an additional negative effect on the economy,” he added.
As the Fed and the Bank of England plot their next moves, they can look to the European Central Bank as an example. Last week the ECB announced another half-point interest-rate increase, while saying that it was “ready to respond as necessary to preserve price stability and financial stability in the euro area.”
The Bank of Canada has more flexibility than its peers. Two days before Silicon Valley Bank failed, Canada’s central bank held its benchmark interest rate steady, becoming the first major central bank to officially pause monetary policy tightening.
Central bank officials left the door open to further rate hikes if needed. Markets expect the central bank to stand pat at its next rate decision in April before starting to cut rates in the summer.