ECB backed itself into a corner ahead of interest rate hike

The European Central Bank (ECB) had backed itself into a corner in advance of last week’s half percentage point interest rate hike. Having signalled the near-certainty of another half-point move in March, opting for a smaller quarter point rise in the face of the market turbulence triggered by the collapse of Silicon Valley Bank (SVB) and the overnight bailout of Credit Suisse might have spooked the markets further.

Dodging the planned rate hike altogether, as some had advocated, would have generated a storm. Investors would have viewed such a sudden shift as meaning things under the bonnet of the Swiss bank or under the bonnet of the banking sector in general are decidedly worse than what we’ve been led to believe.

Conversely, going ahead with the half point rise in the face of such market turmoil will be interpreted as a sign that inflation is much stickier than anticipated, which sends a different type of signal.

The problem for rate-setters is that there’s a perception they know something we don’t; hence their comments are picked over and parsed for clues as to the real state of the world.

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Maybe the ECB has an inside track sometimes, but most of the time it is just waiting for signals from the real economy. ECB chief Christine Lagarde and the bank’s chief economist Philip Lane are blue in the face telling reporters that rate decisions are “data-dependent” and that they themselves don’t know what the terminal point for interest rates will be in the current cycle.

[ Cliff Taylor: There are echoes now of the run-up to the 2008 crash ]

The ECB isn’t immune to getting it wrong either. Historically it has made some spectacularly bad calls. It famously raised interest rates in July 2008, only to reverse tack three months later after Lehman Brothers in the US collapsed and markets nosedived.

Former ECB chief Jean-Claude Trichet also raised rates as Europe’s sovereign debt crisis was developing in 2011, arguing that anchoring inflation expectations was the best way to boost confidence in the single currency. Both moves have gone down in history as major policy errors.

Silicon Valley Bank: what is the cost of the collapse?

Listen | 30:17

The collapse of Silicon Valley Bank (SVB) last week has spooked financial markets, with global banking stocks dropping significantly as a result. With a new CEO at the helm, SVB is declaring ‘business as usual’, but the ripple effects of the bank’s failure can still be felt. To discuss the reasons behind the bank run and the wider implications on markets and the tech sector, Ciaran Hancock is joined by Irish Times columnist Chris Horn and Markets Correspondent Joe Brennan. 

A big problem for the ECB – in the current inflation-driven cycle – is credibility. It was clearly caught out by the initial price surge, downplaying it as a short-term manifestation of the Covid lockdowns and the disruption to international supply chains. Lagarde was using the word “transitory”, predicting the whole thing would blow over in the second half of 2022, right up until Russia’s invasion of Ukraine effectively ended the argument.

Frankfurt was the last of its peers to increase interest rates, opting for an initial half-point rate hike in July last year, long after the Fed, Bank of England and Bank of Canada had begun a process of monetary tightening.

[ UBS offers to buy Credit Suisse for up to $1bn ]

Probably because it is governed by economists, it has always been slower to react and less inclined to submit to market pressures, an accusation often levelled at the Federal Reserve in the US. Over the past 20 years, the ECB has implemented far fewer rate changes than the Fed.

Either way, since July, Frankfurt has been playing catch-up. For idiosyncratic scheduling reasons, the ECB got to go in advance of the Federal Reserve this month, just as banking sector jitters reached fever pitch with talk of contagion and bailouts eerily reminiscent of 2008.

In her press conference after the rate-change decision, Lagarde was adamant there was no trade-off between the ECB’s inflation-taming rate hike and wider financial market stability. That was difficult to take at face value. Monetary policy is all about trade-offs.

The wider tech/financial sector crunch from Meta’s job losses, SVB’s collapse and Credit Suisse’s overnight bailout appear strongly linked to higher interest rates and, in particular, the speed of monetary tightening.

“There is no trade-off between price stability and financial stability. And I think that if anything, with this decision, we are demonstrating this,” she said.

ECB vice-president Luis de Guindos insisted “the banks are resilient”, with high capital ratios, robust liquidity buffers and limited exposure to US institutions.

But that’s like the chairman of a football club vouching for the manager. We’re programmed to see this as a prelude to a sacking. In this case, de Guindos is most likely right as, in the EU, banks are nowhere near as vulnerable as they were back in 2008. Doubly so in the case of the Irish ones.

[ Are banks on the edge of another 2008-style precipice? ]

That said, the financial system seems to have sinkholes that only become visible when something goes wrong. The Bank of England’s recent bond market intervention is a case in point. In September, it was forced to step in after a massive sell-off of UK government bonds – known as gilts – brought pension funds to within hours of collapse. Nobody had seemed to highlight this as a potential risk until it happened.

On Friday, the Organisation for Economic Co-operation and Development (OECD) warned that the full impact of higher interest rates was hard to gauge, noting that the rapid pace of monetary tightening continued to expose “financial vulnerabilities from high debt and stretched asset valuations, and also in specific financial market segments”.

The ECB’s decision “is a test of the conundrum facing central banks”, Adam Hoyes, an economist at Capital Economics, said in a note. “There are still huge uncertainties about what might happen next, but central banks ... will now have to factor in the risk that the current situation snowballs into a broader loss of confidence in the banking system and a significant tightening in financial conditions.”