Central Banks Decided To Continue Their Fight Against Inflation Despite The Banking Crisis

By Phillip Marey, Senior US strategist at Rabobank

Another week of banking turmoil did not halt the fight against inflation for the central banks that were scheduled to make monetary policy decisions this week. However, the Fed seems to have been impacted the most as concerns about credit tightening have averted the rise in the projected peak for the hiking cycle that Powell had announced only a few weeks ago. Nevertheless, we continue to doubt the rate cuts that have been priced in by the markets for this year, as inflation in the US remains persistent.

Banking turmoil

This week saw additional efforts to stabilize the banking system across the globe.

On Sunday, six central banks – the Bank of Canada, the Bank of England, the Bank of Japan, the ECB, the Fed and the SNB – announced a coordinated action to enhance the provision of US dollar liquidity through an increase of the frequency of US dollar swap line operations to daily from weekly, at least through the end of April. The network of swap lines is a set of standing facilities that serve as a liquidity backstop for global funding markets.

First Republic Bank is the third casualty in the US banking turmoil. The similarity to Silicon Valley Bank, being a midsize bank with wealthy clients and largely uninsured deposits, makes it a prime suspect in the eyes of depositors and investors. A $30 billion deposit injection by 11 large US banks, led by JPMorgan Chase and facilitated by the Treasury Department, only provided temporary relief for First Republic. Note that these large banks received major inflows of deposits from midsize banks such as First Republic, so they are basically sending the hot money back. However, First Republic’s stock is still trading at low levels.

The first European casualty of the banking turmoil is Credit Suisse. After depositors fled the bank that has been suffering from scandals and trading losses for years, the Swiss central bank organized a takeover by UBS. The deal was announced on Sunday, with UBS buying Credit Suisse for $3.2 billion and getting a more than $200 billion liquidity line from the SNB and a Swiss government guarantee of $9 billion against potential losses. For more details, we refer to the Bank Bulletin by Paul van der Westhuizen.

During the week, US Treasury Secretary Yellen gave some mixed messages on bank deposit guarantees. On Tuesday, speaking to the American Bankers Association convention, she said the government stood ready to repeat the actions it took in case of Silicon Valley Bank and Signature Bank to rescue uninsured deposits if smaller institutions suffer deposit runs that pose the risk of contagion. Yellen’s remarks shored up confidence in midsize banks as many interpreted her words as a de facto guarantee of all $17.6 trillion in US bank deposits. However, on Wednesday, during a hearing before the Senate Financial Services and General Government Subcommittee, Yellen said that regulators are not looking to provide blanket deposit insurance to stabilize the US banking system without working with lawmakers. This led to an adverse market reaction, in regional bank shares, but also more broadly. Then came another change of tone on Thursday when she testified before the House and said that “we would be prepared to take additional actions if warranted.” On balance, it remains unclear how far the Treasury exactly is willing to go with raising deposit insurance, which contributes to market anxiety regarding the banking sector.

Decision time

This week was decision time for several monetary policy committees around the world. After the breakout of the banking turmoil, and efforts to stabilize the banking system, the Fed, the Banco Central do Brasil, the Bank of England, the Swiss National Bank, Norges Bank and the Bank of England had to decide how much impact the financial instability was going to have on their monetary policies. A week before, the ECB had already raised the policy rate by 50 bps with ECB President Lagarde stressing that there is no trade-off between price stability and financial stability, and that several facilities are available should they be needed. In fact, our ECB watchers already noted that the Fed’s new Bank Term Funding Program (BTFP) reminds them of the ECB’s series of (T)LTROs.

On Wednesday, the FOMC unanimously decided to raise the target range for the federal funds rate by 25 bps. However, wary of the banking turmoil and its impact on the economy and inflation, the FOMC does not want to go much higher and expects only one more 25 bps rate hike this year. Instead, the FOMC expects credit tightening by banks to do the rest of the inflation fighting for the central bank. Consequently, we have lowered our forecast for the target range of the fed funds rate to 5.00-5.25% from 5.25-5.50%. In other words, we now expect only one more hike of 25 bps instead of two. However, because of persistent inflation, we stick to our forecast that the FOMC will not cut rates this year. For more details, we refer to our FOMC Post-Meeting Comment.

Also on Wednesday, for the fifth time, the BCB‘s Copom unanimously decided to keep the Selic rate at 13.75%. The decision was in line with what we and the market had predicted. The Copom reinforced once again that they will remain “vigilant” and assess if holding the Selic rate for a sufficiently long period will drive inflation back to levels around the targets. And they hawkishly reiterated that they would not hesitate to resume tightening if need be, to reanchor inflation expectations. Going forward, we maintain our expectation that easing is not in sight until 2023Q4. We expect the Copom to keep the Selic rate at 13.75% until the November meeting when a cutting cycle begins, but we now add an upward bias to our 2024Q4 Selic rate forecast of 8.50%. For more details we refer to the BCB Post-Meeting Comment by Mauricio Une and Renan Alves.

On Thursday, it was decision time for several central banks in Europe. The SNB raised its policy rate by 50 bps to 1.5%. Swiss inflation is lower than in other European countries, but has been rising. The SNB said that “it cannot be ruled out that additional rises in the SNB policy rate will be necessary to ensure price stability over the medium term.” Regarding financial stability, the SNB said that the takeover of Credit Suisse by UBS, facilitated by the SNB, had “put a halt to the crisis.” Norges Bank raised its policy rate by 25 bps to 3.00%. Governor Ida Wolden Bache said that “there is considerable uncertainty about future economic developments, but if developments turn out as we expect, the policy rate will be raised further in May.”

Also on Thursday, the Bank of England raised its policy rate by 25bps to 4.25%. This was in line with our own expectations and with market pricing after the publication of the ‘hot’ February CPI report. The vote was split 7-2-0, with external members Tenreyro and Dhingra voting for a hold. The BoE will tighten policy further in May if price pressures persist and credit conditions permit. The shift to a meeting-by-meeting approach is not as dovish as some expected. The Monetary Policy Committee continues to focus on labor market tightness and what this means for wage and services inflation. We see risk that tightness persists. The Financial Policy Committee has judged that the UK banking system remains resilient, effectively giving the green light to this rate increase. For now, we hold on to our long-held view that Bank rate could rise as high as 4.75% with the next 25bps hike in May. This requires that global financial stability risks remain contained. For more details, we refer to the Bank of England Post-Meeting Comment by Stefan Koopman.

Overall, central banks decided to continue their fight against inflation this week, despite the banking turmoil. However, in particular the Fed has become more careful. Only a few weeks ago, prior to the collapse of SVB, Powell said that there would be an upward revision to the rate projections at the March meeting. However, this week the peak of the projected hiking cycle remained unchanged from the previous projections in December. Concerns about credit tightening are already playing a central role in the Fed’s mind, in contrast to other central banks