The interest rate dilemma: Smash inflation but don't destabilise the banks

Central bankers still need to squash inflation, but can they do so without damaging the banks, asks Matthew Davies

US Federal Reserve chairman Jerome Powell after the Fed raised interest rates by a quarter of a percentage point, on March 22. Reuters

Central banks across the Gulf raised interest rates on Thursday, after a rise by the US Federal Reserve.

The Central Bank of the UAE raised the base rate on the Overnight Deposit Facility (ODF) by 0.25 per cent, from 4.65 per cent to 4.90 per cent.

Meanwhile, the central banks in Saudi Arabia, Bahrain and Qatar also raised their interest rates by 0.25 per cent.

In Europe, the Swiss National Bank (SNB) raised rates by 0.5 per cent, while Norway's central bank increased its rates by 0.25 per cent 3 per cent, the highest level since 2009.

The Bank of England put its rates up by 0.25 per cent to 4.25 per cent, its 11th successive rate rise

In this current interest rate cycle, which started in late 2021, 10 developed economies have raised rates by a combined 329 per cent to date.

But have they worked? Is inflation tamed? Or did the rate rise push some banks too far, too fast?

The chair of US Federal Reserve, Jerome Powell, is criticised by one or another quarter no matter what he and his team at the Federal Open Market Committee do with interest rates: Raise them by too much, too little, leave rises too late, move too soon, and so on.

For someone, who it's sometimes argued has the responsibility of holding the world's financial system together, he's paid just $190,000 a year, a figure dwarfed by the millions and tens of million in salaries that corporate leaders in America command.

But he's the man they look to in times of crisis. So, are we in another crisis?

Most analysts, regulator and politicians have been saying no, we're not. This is not 2008 and the risk of a systemic failure of the banking system is very low. There's no Lehman Brothers on the horizon. At the moment.

What there is, is a product of several things: the end of the era of cheap money, the war in Ukraine and the accompanying energy crisis, more than 18 months of rising inflation and correspondingly rapid interest rate rises. All against the background of a global economy recovering from a pandemic.

It's often said that monetary policy is quite clumsy by nature. Using interest rates to control inflation is like using a sledgehammer to crack a nut.

The trouble is, currently it's like using a sledgehammer to crack the outer shell of the nut, leaving the interior unscathed.

And there's a lagging effect with interest rates, so you don't absolutely know for sure where the nut will be at any given time.

The current dilemma

The rapid rise in interest rates over 2022, not just in the US but in most of the world's major economies, was a shock that was months in making.

A couple of weeks ago, Silicon Valley Bank, where tech entrepreneurs put their money and borrowed from, started to have real problems.

Banks take in deposits that have a short maturity and invest them in securities and loans that have a long maturity. The difference in interest rates between these two is how they make their money.

One of those investments is often US Treasuries, deemed to be as safe as houses — you're loaning money to the US government and they're good for it.

The trouble is as interest rates go up, the yield on the bonds increases and the price drops. Combine that with a fall off in confidence and you've got a problem.

Depositors at SVB started getting nervous and the first thing a nervous depositor does is withdraw their money.

But to cover that, SVB had to sell the government bonds and got less for them than they paid a year ago, because of rising interest rates.

Security guards let people into the Silicon Valley Bank's headquarters in Santa Clara, California, on March 13. AP

Less confidence, more withdrawals and then panic. A run on the bank. It was the biggest bank failure since 2008. Signature Bank, which was involved in cryptocurrencies, was not far behind.

That led to a reassessment of the whole sector. Analysts took to their computers to recalculate risks associated with the banks. After all, using depositors' money to invest in government bonds made sense and is widespread practice.

Then it was the turn of Credit Suisse.

Switzerland's second-largest bank didn't have the same problems that SVB had. Credit Suisse's worries had been many years in the making: scandals, top management changes and an uninspiring turnaround strategy that was delivering little more than losses.

But like SVB, depositors were rapidly losing confidence. Credit Suisse confirmed in February that clients had pulled 110 billion Swiss francs ($119 billion) of funds in the fourth quarter of 2022.

So, both SVB and Credit Suisse were staggering towards oblivion. But central bankers needed to intercept them before they staggered over a cliff, because if either went into an unorderly meltdown, contagion was sure to follow.

The Credit Suisse Group office tower in Zurich, Switzerland, on March 16. Bloomberg

This was especially true of Credit Suisse, one of the world's 30 most systemically important banks, whose failure would cause ripples through the entire financial system.

So the Federal Deposit Insurance Corporation stepped in to prop up SVB, or to bring some order to its collapse.

HSBC paid £1 for SVB's UK operations and Swiss rival UBS bought Credit Suisse for 3 billion Swiss francs, a 60 per cent discount to its market value just days before.

“This acquisition is attractive for UBS shareholders but, let us be clear, as far as Credit Suisse is concerned, this is an emergency rescue,” UBS chairman Colm Kelleher said.

“It is absolutely essential to the financial structure of Switzerland and … to global finance."

There were sighs of relief all round, not least by the central bankers who would have been at the centre of the storm that would have engulfed the financial system if arrangements were not made.

What SVB and Credit Suisse also brought into sharp relief was the speed at which bank fallout can spread. Back in 2008, social media was scant. Twitter and Facebook were barely more than infants.

But because of social media, the loss of confidence in SVB and Credit Suisse spread far quicker than the rumours that something was amiss at Lehman Brothers 15 years ago, which simply creates a further challenge for central bankers trying to bring stability during potential crises.

Social media is a "complete game-changer" in bank runs, Citigroup chief executive Jane Fraser told the Economic Club of Washington.

The whole saga has also exposed the cracks in the system, and many were asking the question: Was the whole thing, especially the SVB issues, the fault of the central banks in the first place? Is this what happens when you accelerate interest rates from 0 to 4.75 per cent in less than year?

The US Federal Reserve building in Washington. Reuters

A trilemma, really

So now the central bankers are faced with a trilemma, a three-pointed problem.

Raise interest rates too aggressively and you risk not only pushing an economy into recession, but widening the cracks the financial system.

Don't raise them enough and inflation could get worse, and that erodes people's money and their ability to spend it.

The European Central Bank was the first major regulator to shrug off the wilder concerns about bank stability when it went ahead as planned and lifted rates last week.

The US Federal Reserve increased them, but only 0.25 per cent, in a nod to the problems of the banks, and to inflation, saying: "We haven't forgotten about you."

“We have to bring inflation down. There are real costs of bringing it down to 2 per cent, but the costs of failing are much higher,” Mr Powell said.

The Bank of England was reminded that inflation is still very much around on Wednesday when the latest UK figures showed an increase, after a few months of decline.

Likewise, the Bank of England then raised interest rates by 0.25 per cent on Thursday.

"The Fed Reserve, along with the major central banks, is clear in its position that the recent turmoil does not pose a risk to the wider financial system," said Richard Flax, chief investment officer at wealth manager Moneyfarm.

Traders on the floor of the New York Stock Exchange on March 23. Getty via AFP

So what now?

Is the banking crisis over? Has inflation been tamed? Have interest rates peaked?

All valid questions and the honest response from many economists would be: "Ask me six months."

As far the banking crisis goes (if, indeed, it could be described as a full-blown crisis) confidence is nudging back and gaining ground. But the problem with confidence is that it can lost in minutes and take months to rebuild.

In the US, it's been nearly two weeks since SVB went under, a week since Signature signed off and now the latest US bank to wobble, First Republic, has been propped up. Credit Suisse's UBS lifeline is less than a week old.

Bank shares in Europe and the US recovered somewhat, but the underlying feeling in markets remains downbeat. Many are adopting a wait-and-see approach.

That approach might just be the phase that central banker are entering as well. The effects of interest rate rises take months to feed through into economies.

Timing is everything. The Fed is widely blamed for not increasing rates fast enough back in 2020 and 2021.

It was keeping rates around zero even up to the first quarter of 2022, and was still buying billions of dollars of bonds every month to stimulate the economy, as inflation approached 40-year highs.

But when it did increase, it increased strongly and many now say it was all too much, too late.

However, the Fed and the other major central banks have a job to do, battling inflation. That job may now be done as the effects of successive rate rises feed through.

Also, it's been pointed out that the banks may indulge in a little tightening of their own, being more prudent and circumspect with loans.

It is hoped that interest rates will now take a pause for thought. Economists think it may take slightly longer for inflation in the US to get back down towards its target level.

There could well be one more rise in interest rates in store in the US, the UK and the eurozone before the year is out.

"The Fed is now living on a hope and a prayer that they haven’t done irreparable harm to the banking system," said Brian Jacobsen, senior investment strategist at Allspring Global Investments.

"The Fed is probably thinking financial stresses are substituting for future rate increases."

While central bankers will be using the phrase “monitor closely” a lot over the coming months, a degree of jitteriness is still likely to prevail.

"Everyone is feeling a little bit edgy and the shift in tone from the Fed to 'some policy firming may be appropriate' from the previous line of 'ongoing hikes' has just led to more uncertainty," said AJ Bell investment director, Russ Mould.

There was also "concern the Fed sees further vulnerabilities in the financial system which are still to be tested", he said.