ECB sets the template for rates hikes in a time of instability

European Central Bank President Christine Lagarde speaks during a news conference following the ECB's monetary policy meeting in Frankfurt, Germany March 16. Reuters-Yonhap

After a week of tension in financial markets the European Central Bank became the first mover in a global test of how concerns about a potential banking crisis may influence monetary policy ― and kept its focus at least for now on fighting inflation with a half-point rate increase.

Foreshadowing a risk-management decision the U.S. Federal Reserve will face next week, the ECB's policy statement on Thursday led with what has become a common refrain among central bankers ― "inflation is projected to remain too high for too long" ― while insisting it can ensure financial stability even as interest rates keep rising.

"We are not waning on our commitment to fight inflation ... The determination is intact," European Central Bank President Christine Lagarde said in remarks after the policy decision. "There is no tradeoff between price stability and financial stability ... we are addressing the price stability issue by raising the interest rate by 50 basis points ... Separate from that we are also monitoring market tensions" and would be prepared to provide additional support for financial institutions if necessary.

Lagarde's firewall between two complex problems is something Fed officials also are likely to embrace, and hope it proves effective as they decide how to balance their own unfinished inflation battle against concerns their aggressive rate hikes over the last year are beginning to bite harder on the economy.

Lagarde said her outlook was conditioned on a "baseline" projection set before the failure of Silicon Valley Bank in the U.S. last week, the announcement by the Fed of a new liquidity program as a result, and new uncertainty closer to home in the troubles faced by Credit Suisse, an institution domiciled outside the eurozone but deeply connected.

U.S. policymakers will have had more time to digest market developments before their March 21-22 meeting, and build that into their rate decision as well as into longer-term projections for where the economy and monetary policy are heading in coming months and years.

Recent U.S. economic data has given the Fed little reason to declare victory over inflation, with consumer prices still rising at a 6% annual rate and only initial indications of a significant easing in hiring and wage growth - something U.S. policymakers feel will be needed for inflation to cool.

Jobless claims fell below 200,000 for the week ending March 11, while February housing starts surged, unexpected strength from one of the sectors of the economy considered most sensitive to rising interest rates.

After volatile moves in bond and rate futures markets this week, traders in securities tied to Fed policy expected ― at least as of midday Thursday ― that the U.S. central bank would move ahead with another quarter-point rate increase.

Credit Suisse at London's financial district Canary Wharf, in London / EPA-Yonhap

Sending a message

But the messaging around it will matter, and indicate just how heavily policymakers weigh recent events.

In testimony before the U.S. Congress on Thursday, Treasury Secretary Janet Yellen echoed Lagarde's diagnosis that controlling inflation remained the top priority, and that recent financial market troubles were not the start of a wildfire.

"There was a liquidity risk in this situation," Yellen told the Senate Finance Committee, but the system remained sound particularly after the "decisive and forceful" actions taken by U.S. officials to protect Silicon Valley Bank's depositors and provide new Fed loans should other banks need them.

It is a message the Fed is likely to reinforce. In repeated reports, analysis, and public statements Fed policymakers have trumpeted the strength of the banking system, maintaining its higher levels of capital and other safeguards have made it far more resilient to unexpected shocks than it was in 2007, when a crisis in the U.S. housing market sparked a global unraveling.

Having added, in rapid fashion, a new liquidity program to address some of the issues raised by the collapse of Silicon Valley Bank, changing direction on monetary policy "would concede early defeat on the regulatory front," wrote Benson Durham, head of global policy for Piper Sandler.

Beyond the rate increase, the Fed will also be debating changes to its policy statement that could prove consequential.

Silicon Valley Bank's collapse through one lens seems largely the result of bad management and a flawed business model. By another it shows the stress rising interest rates are having on bank balance sheets stuffed with U.S. government and government-backed debt - all of which decline in value when market interest rates rise.

In crafting their next policy statement officials will have to decide, for example, whether to continue to anticipate the need for "ongoing increases" in the policy interest rate, or to temper that seemingly open-ended commitment with language that indicates rate hikes could pause at any moment, given the new risks.

They will also be issuing new economic and interest rate projections that could add a further dose of caution.

The Silicon Valley Bank failure has rattled the outlook for a host of lenders outside the class of behemoths like JP Morgan, highlighting how smaller institutions have faced increased competition for deposits, and amid signs at the national level that credit is beginning to tighten and issuance slow.

U.S. Treasury Secretary Janet Yellen testifies about the Biden Administration's FY2024 federal budget proposal before the Senate Finance Committee in the Dirksen Senate Office Building on Capitol Hill, March 16, in Washington, D.C. AFP-Yonhap

Following the events of the last week economists have begun downgrading their U.S. growth forecasts and raising the perceived risk of recession, partly on the expectation that banks are going to become stingier with loans to businesses and households ― an aspect of Fed policy that has been waiting to kick in.

"Tighter credit and financial conditions will represent a drag on the U.S. economy" this year and into 2024, wrote EY-Parthenon Chief Economist Gregory Daco. "While the economic landscape may look benign one day, an abrupt shift in sentiment and financial conditions could lead to a recessionary environment the very next day if everyone starts retrenching." (Reuters)