The European Central Bank raised its benchmark interest rate by half a percentage point Thursday, prioritizing its fight against inflation amid growing concerns about the health of the global financial system.
A week ago, the 50-basis-point move was seen as a sure thing. But the failure of California-based Silicon Valley Bank and turmoil at Swiss lender Credit Suisse called into question how much the ECB would continue tightening monetary policy.
On Wednesday, Credit Suisse, Switzerland’s second-largest bank, said it would borrow up to 50 billion Swiss francs ($73.8-billion) from the Swiss central bank to shore up its liquidity position and allay fears of a bank run.
ECB president Christine Lagarde said Thursday that the ECB was “monitoring current market tensions closely and [stands] ready to respond as necessary to preserve price stability and financial stability in the euro area.”
Thursday’s decision lifts the ECB’s benchmark deposit rate to 3 per cent, the highest level since 2008.
Central banks are facing a dilemma that has crystallized over the past week. After raising interest rates at the fastest pace in a generation to combat high inflation, cracks are emerging in corners of the financial system on both sides of the Atlantic. That heightens the tension between restoring price stability, by continuing to raise interest rates, and adding to financial system woes.
Monetary authorities tend to cut interest rates during periods of financial market strain. However, the current banking sector upheaval is happening at a time of elevated inflation – a dynamic not seen since the 1980s, which puts central bankers between a rock and a hard place.
Rising interest rates have cratered bond prices, leaving large unrealized losses on the balance sheets of many financial institutions. That proved deadly for Silicon Valley Bank, which was forced to sell a portion of its bond portfolio at a large loss to meet customer withdrawals, sparking a run on the bank.
“When you pull back central banks from the bond markets and reduce bank reserves and liquidity, eventually you wind up exposing some skeletons on the beach,” said Derek Holt, head of capital market economics at Bank of Nova Scotia. “I think that’s what we’re faced with now.”
Central banks are having to step back into their role as lenders-of-last-resort. The Swiss central bank’s decision to offer a lifeline to Credit Suisse is reminiscent of moves by central banks during the 2008 financial crisis. Similarly, the U.S. Federal Reserve announced a US$25-billion lending facility on Sunday, giving regional U.S. banks the ability to swap their illiquid assets for cash in the event of bank runs.
Although financial stability concerns have come to the fore, inflation remains the key concern for central bankers. Annual consumer price inflation was running at 8.5 per cent in the euro area in February – more than four times the ECB’s 2-per-cent target. It was 5.9 per cent in Canada in January and 6 per cent in the United States in February.
“Inflation is projected to remain too high for too long,” Ms. Lagarde said, while adding that the ECB’s latest economic projections were finalized before the recent market tensions. She said that the central bank would take a “data-dependent” approach to future interest rates decisions.
The ECB dropped an earlier commitment to “stay the course in raising interest rates significantly at a steady pace” from its rate announcement statement on Thursday.
“Altogether, it seems to us that the ECB has negotiated today’s awkwardly timed policy announcement pretty well,” Adam Hoyes, market economist with Capital Economics, wrote in a note to clients.
“It has managed to pull off arguably the riskiest option – a 50 bp hike – which maintained the credibility of its commitment to price stability and prompted a decline in inflation swap rates, without prompting any further volatility in financial markets.”
At the same time, Mr. Hoyes added, “price stability may take more of a back seat as a driver of global financial markets in the months ahead.”
Over the past week, investors have slashed their bets on how much further central banks will lift interest rates. That led to huge moves in the bond market. The yield on two-year U.S. Treasuries is almost a percentage point lower than a week ago – the sharpest repricing since the 1980s.
Interest rate swaps, which capture market expectations about future monetary policy decisions, went from pricing another 100 basis points of rate hikes by the U.S. Federal Reserve in the coming months, to pricing in only 50 basis points of tightening, followed by rate cuts starting this summer. Markets expect the Fed to raise its benchmark rate by 25 basis points at its next meeting on March 22, according to Refinitiv data.
Expectations have also shifted for the Bank of Canada, which paused its monetary policy tightening campaign last week. Swap markets are pricing in no more Canadian rate hikes, and at least two quarter-point rate cuts by the end of the year.
Benjamin Reitzes, Bank of Montreal’s director of Canadian rates and macro strategy, said bond investors have become increasingly pessimistic over the past week.
“They are pricing crisis,” Mr. Reitzes said. “If this doesn’t get substantially worse, the pricing is way too aggressive. But fear wins.”
The sharp bond market moves have gummed up trading, with market participants reporting the worst trading environment since the early days of the COVID-19 pandemic. Buyers and sellers have become skittish, slowing down the speed of trades and blowing out the bid-ask spread on even the safest government bonds.
“It’s clear there’s stress in the market. And there should be when you’re getting 20, 30, 40, 50-basis-point moves on a day-to-day basis,” Mr. Reitzes said. “There’s no real way to really effectively and consistently protect yourself from that if you’re an investor, and so that’s keeping everybody very cautious.”