Monetary policymakers are living in interesting times, as they cater to one crisis after another.
First, the Covid-19 pandemic forced them to throw all caution to the winds, slashing interest rates to record lows and expanding their balance sheets to record highs. They held steady, seeing through supply-side issues, deglobalisation and the US-China economic tussle. Meanwhile, demand stimuli pushed inflation higher.
Finally, Russia’s invasion of Ukraine pushed inflation to decadal highs across the globe, leading to a coordinated and sharp withdrawal of pandemic era easy policies.
Until last week, it seemed that developed market central banks, starting with the Federal Reserve and the European Central Bank, were due to embark on another set of rate hikes as fears of a global recession seemed unfounded after a spate of robust economy data and following the China opening.
However, the collapse of the Silicon Valley Bank and Signature Bank in the US has put paid to talks for ‘higher for longer’ for now. Or so markets expect.
Remember, the Federal Reserve has tightened policy by a whooping 450 basis points over the last year, straining the financial sector. The SVB crisis was in a way the lagged impact of the past rate hikes that are starting to bite.
The markets were betting on a 50 basis-point hike at the March 21-22 meeting before last weekend. They have now slashed these expectations to 25 basis-point hike or a pause. Goldman Sachs was one of the first ones to call for a pause
“If it hadn’t been for SVB, the Fed would have little reason to hesitate over 50bp next week but 25bp looks more likely,” according to a March 15 investor note by Societe Generale. “The FOMC should land on 25bp barring further deterioration in financial conditions in the coming days.”
In fact, doubts have also emerged in some quarters if the ECB will deliver a 50 basis points rate increase this week or shift it down to 25 basis points.
To be sure, central banks face the dilemma of whether to abandon their renewed hawkish push because of the SVB crisis, which might well be contained due to the lack of contagion effects like in the recession following the sub-prime crisis of 2007.
“Even if the crisis ends up being resolved relatively quickly, we suspect it will result in a lasting tightening in credit conditions as banks shore up their balance sheets, which will eventually hit economic activity,” Andrew Hunter, Deputy Chief Economist at Capital Economics, said.
“In that context, although the CPI data increase the chances of the Fed continuing to hike next week, albeit by no more than 25bp, we doubt officials will be rushing to signal significant further tightening beyond that.”
Likely EM, India impact
While policymakers usually like to say that their monetary policies are geared primarily towards their own economies, often they end up dancing to the tune of the Federal Reserve.
Now, with the Fed seemingly caught in a tight spot, emerging market central banks have more breathing space to stop hiking if they want to.
Already, Vietnam this week slashed a key policy rate by 100 basis points, becoming the first Asian country to pivot.
So far, it doesn’t look like EMs have suffered large capital outflows or strains in their banking sectors, according to Capital Economics.
“If this relatively benign scenario persists, EM central banks might begin to ease monetary policy sooner than we currently have in our profile. But otherwise the macro implications will be limited. In a more malign scenario, however, the growth outlook for EMs would be altogether much worse,” it added.
India’s rate-setting panel meets in April for its next policy decision. The panel was widely expected to raise rates again as inflation remains stubborn above its tolerance ceiling but there is a growing chorus of voices asking for moderation.
"It takes a few quarters for interest rate rises to take effect on demand and demand-led inflation and it is appropriate to watch for some time, allow these to take effect," Ashima Goyal, a member of the India’s Monetary Policy Committee, said on March 15.
“You cannot just keep raising rates until inflation starts falling. That is a recipe for over-reaction, overtightening and creating financial instability,” Goyal said.
Goyal, one of the six members of the rate-setting panel, has also been advocating for a pause to rate hikes in India, where policy has been tightened significantly over the last year.