Central banks hold the line on inflation amid stress in financial markets

Central banks in the US, the eurozone and the UK all raised interest rates over the last couple of weeks, despite the substantial stress in financial markets following the collapse of two US banks and the forced purchase of Credit Suisse by UBS.

The European Central Bank was the first to move with a 50-basis point rise on March 16, taking the main refinancing rate to 3.5 per cent. The Federal Reserve and the Bank of England followed last week with 25 bps increases to benchmark rates, taking them to 5 per cent and 4.25 per cent, respectively.

The decisions highlighted policymakers’ commitment to bringing inflation back down towards the 2 per cent target, and also served to show confidence in their banking systems.

ECB President Christine Lagarde was clear that there was “no trade-off” to be made between price stability and financial stability, and that central banks had the tools to insure the latter while raising rates to achieve the former.

Messaging from the Fed and the Bank of England was a little softer, with Fed Chairman Jerome Powell acknowledging that the Federal Open Market Committee (FOMC) had considered pausing this month, before deciding that the banking system was resilient enough for them to raise rates.

He said inflation was still too high while the new economic projections showed that the

Fed did not expect inflation to fall to 2 per cent until the fourth quarter of 2025. Nevertheless, the FOMC’s interest rate projections – the dot plot – showed that the Fed is probably close to the end of its interest-raising cycle, with one more 25 bps rate increase forecast this year.

The BoE’s monetary policy committee was also relatively dovish in its post-meeting statement, saying that it expected inflation to fall “sharply” over the rest of the year, despite the surprise acceleration in UK consumer inflation to 10.4 per cent annually in February.

The challenge for central banks is threading the needle on inflation and the real economy. The inflation data suggests that more tightening is necessary to cool demand. Inflation figures for February suggest that core inflation, excluding food and energy costs, is very sticky at a high level across developed markets.

Eurozone core CPI rose to 5.6 per cent year-on-year last month, while UK core inflation surged to 6.2 per cent in February from 5.8 per cent in January.

US core CPI softened fractionally on an annual basis but remained high at 5.5 per cent.

However, the recent instability in the banking sector means that banks – particularly the smaller ones at risk of bank runs – could aggressively tighten their credit standards and cut back on lending. This could have the effect of another one or two rate increases in terms of dampening growth, or push the economy into a recession.

Central banks may then not need to increase rates further to bring inflation down. This seems to be what the market is banking on – Fed Funds Futures are pricing at least three 25 bps rate cuts by the end of the year in the US.

While policymakers believe they have ring-fenced the troubled banks and provided sufficient liquidity to allow other banks to meet their depositors’ withdrawal requirements, there is a significant amount of uncertainty about the impact this bout of financial stress will have on the real economy.

The size of the Fed’s balance sheet has grown by $400 billion over the past two weeks as banks have tapped into the liquidity facilities provided by the central bank. However, the amount borrowed by banks last week was significantly smaller than in the week to March 15, when Silicon Valley Bank and Silvergate were taken over by regulators, indicating that the situation has stabilised for now.

It remains to be seen by how much banks curb lending to repair their balance sheets, and the impact that this will have on the real economy and unemployment.

The recent instability in the banking sector could push lenders to aggressively tighten their credit standards