Price stability or financial stability. The European Central Bank has been in a dilemma since the US banking crisis last week in the US and will need to send a clear signal Thursday.
Until the banking crash in the US late last week, it was a foregone conclusion the European Central Bank (ECB) would raise key rates another half percentage point at its meeting on Thursday. It would mark the sixth consecutive hike since it began raising rates in July of last year.
Despite the banking sector turmoil, it remains plausible the half-percentage point increase in the deposit rate to three percent telegraphed by the ECB at its February meeting won’t shake financial markets. ECB President Christine Lagarde stressed at the time that only extreme developments could still upset the roadmap to another March rate hike.
For observers, however, Thursday’s rate hike is not the most imcrucialessage. Instead, they will keenly be looking for signals about the upcoming meeting in May. In light of recent events, the odds have changed.
Traders scaled back their bets at the beginning of the week. According to a report, tha hike of 25 basis points in May is re likely than a 50 basis point move.
The deciding factor for the further pace of key rate hikes will be how quickly the ECB expects inflation to fall toward its two percent target. So far, the prevailing view among analysts is the deposit rate will peak at four percent in July.
However, the banking crisis emanating from the US and the possible contagion risks to other regions could change that assessment. To be sure, further monetary tightening is still urgently needed to curb high inflation, but at the same time, they threaten to further jeopardize financial stability, which has been battered above all in the US.
Central banks are faced with a classic dilemma. According to Klaus Wellershoff of the Zurich-based wealth advisor Zwei Wealth, the monetary guardians have to choose between more future inflation or exacerbating the banking crisis. He said this balancing act is fundamentally different from the financial crisis of 2007 to 2009.
Then, central banks were able to achieve both financial and price stability at the same time because of the threat of inflation that was too low, Wellershoff said.
Because inflation rates are currently above central bank targets by a wide margin, their options depend on how the US banking crisis plays out in the coming days. Wellershoff expects that central banks won’t be able to ignore financial stability and will put on the brakes. The past few days’ events make higher inflation likely in the future.
How badly financial stability suffers from California’s Silicon Valley Bank (SVB) collapse is currently the big question, even for central bankers.
For the optimists, the events surrounding SVB do not pose a systematic risk because it was primarily active in a relatively small group of large depositors from startups in the technology and life sciences sectors.
That’s why contagion would be limited and mainly confined to private equity and venture capital, says Rohan Reddy, research analyst at US asset manager Global X ETF, for example.
SVB is not on the Financial Stability Board’s list of systematically important banks, explained in part by SVB’s $175 billion in customer deposits, whereas US GDP in 2021 was $23 trillion.
Those $175 billion won’t vanish entirely into thin air, and depositors would likely get back a substantial portion of their deposits.
What speaks against the US crisis spreading to Europe is the ECB has been slower to raise interest rates than the Fed, leaving banks still have plenty of cheap funding.
In addition, European banks are required to hold more liquid assets than would flow out in a 30-day stress scenario. In the U.S., these rules apply only to the largest banks – and not, for example, to SVB, as is pointed out at Citigroup.
