Banking turbulence is not a reason to pause monetary tightening

Despite banking turmoil and calls for interest rate hikes to be paused, the European Central Bank (on 16 March), the Federal Reserve (on 22 March) and the Bank of England (on 23 March) have raised rates. This was the right decision.

Some observers have emphasised that a pause in interest rate hikes could have been interpreted as central banks fearing for the health of the banking system, which might have undermined trust in banks further.

But a pause would also have raised an even more important medium-term worry: yielding to mild signs of banking trouble could have implied giving up on the fight against inflation when it exceeds the 2% target significantly and labour markets are strong. This would have undermined trust in the central bank’s determination to keep inflation under control. The result could have been an increase in inflation expectations and increased uncertainty about the duration of the current inflation surge, potentially resulting in a more lasting and painful adjustment.

Current banking troubles are concentrated on particular banks with specific issues. Silicon Valley Bank in the United States had a risky business model and inadequate risk management processes. Credit Suisse was under pressure because of money laundering, corruption and spying scandals, made a big loss in 2022 and was expected to make losses in 2023 too. Its annual report published in the midst of its crisis acknowledged material weaknesses in its internal controls over financial reporting and risk assessment processes. When deposits evaporated from Credit Suisse, other banks, including UBS and Deutsche Bank, reported unusually high deposit inflows, suggesting that trust in a few institutions was undermined, but not in the banking system as a whole. Euro-area banks do not suffer from the problems of Silicon Valley Bank or Credit Suisse, while tightened banking regulation and bank supervision since the 2008 global financial crisis has made banks more resilient. The same applies to large US banks.

Inflation, meanwhile, remains stubbornly high and unemployment remains close to historical lows. While the ECB has revised its headline inflation forecast for 2023 down from 6.3% in its December forecast to 5.3% in its March forecast – most likely due to the unexpected fall in energy prices over the past three months – it has revised its core inflation forecast (which excludes volatile energy and food prices) up from 4.2% to 4.6%. The employment growth forecast for 2023 has been revised upward (from 0.4% to 0.8%), while the unemployment rate forecast has been revised downward (from 6.9% to 6.6%). Wage growth remains robust, and the ECB has slightly revised upward its 2023 forecast for compensation per employee from 5.2% to 5.3%.

The ECB’s main deposit interest rate had just reached 3% when the latest February headline inflation figure was 8.5% and core inflation was 5.6%. In most past monetary tightening episodes, the central bank’s interest rate was raised to above inflation. Even if there were some reductions in the equilibrium interest rate over the past few decades, this time, the ECB’s interest rate is still much lower than inflation.

In the context of high inflation, low unemployment, robust wage growth and so-far feeble interest rate hikes, isolated banking problems do not justify a pause in monetary tightening.