Banking instability casts a shadow over ECB rate hike prospects
Policymakers at the European Central Bank (ECB) are gathering on Thursday amidst extraordinary market volatility that may push them to abandon plans for another significant interest rate hike even though inflation is still too high.
The ECB should hike rates by another 50 basis points (bps) on Thursday after starting a drive to slow down price inflation that has seen it do so at its quickest rate ever.
But, the failure of Silicon Valley Bank last week in the United States has sparked worries about stress in the banking industry and sent shares plunging, with Credit Suisse, which has long been plagued by issues, at the epicentre of the meltdown in Europe.
The ECB has to balance upholding financial stability in the face of overwhelmingly imported turbulence with its reputation for battling inflation. On Thursday, the European Central Bank, responsible for the monetary policy of the 20 countries using the euro, announced that their deposit rate will rise by 50 basis points to 3%. This move will create additional complexity in their operations.
Inflation in the eurozone was 8.5% in February, well over the ECB’s target of 2% but well below its high of last autumn. The prognosis will remain bleak. The new statistics should continue to show price rise well above the target in 2024 and slightly above in 2025, a source with direct knowledge told Reuters, despite forecasts for headline inflation being reduced due to the decline in energy costs.
In the meantime, forecasts for underlying inflation, a measure of how long price rises will last, should rise, signalling that disinflation will last a while and that monetary policy must stay strict. This forecast is so unsettling that many officials had called for rate hikes to continue into March even before the turbulence in the banking industry.
What now: upcoming rate hikes?
Markets have reduced their expectations on the amount of Thursday’s move and upcoming rate hikes because they continue to question the ECB’s resolve. However, according to money market pricing, investors only expect a 40-45% possibility of a 50 bps increase, down from 100% last week but still higher than the 20% priced earlier this week.
The unpredictability coincides with Credit Suisse’s announcement that it would borrow up to $54 billion from the Swiss National Bank to boost liquidity after its share price decline heightened concerns about a worldwide banking crisis.
Some said the banking stress was severe enough for the ECB to abandon its recommendations and scale down its tightening intentions. The maximal ECB rate, sometimes called the terminal rate, is currently estimated at 3.25 per cent, down from 4 per cent last week.
Even though there is still a predisposition in favour of higher rates, the ECB will almost certainly abandon its prior habit of signalling its next action and keep the door open for the May meeting.
ECB President Christine Lagarde will likely make an effort to reassure investors about the state of the bloc’s banks, claiming that they are more liquid, lucrative, and well-capitalized now than they were during earlier tumultuous times.
But, given that it recently eliminated a subsidy from a crucial liquidity facility to wean lenders off central bank funds, the ECB is likely to refrain from proposing explicit measures to assist banks.
Lagarde might yet convey that the ECB is ready to intervene should contagion begin to impact the well-being of euro zone lenders negatively, preventing the ECB from successfully implementing its monetary policy.