The ECB is learning the hard way that precommitting on interest-rates is a mistake

Today the focus is on Europe and the Euro area. In some ways that is quite an achievement in a week which has seen several US banks fail. But we can look at things via the Two Worlds Collide theme of INXS as we wonder how this.

 In view of the underlying inflation pressures, we intend to raise interest rates by another 50 basis points at our next monetary policy meeting in March and we will then evaluate the subsequent path of our monetary policy. ( ECB President Lagarde)

Goes with this?

Credit Suisse plans to borrow up to SFr50bn ($54bn) from the Swiss central bank and buy back about $3bn of its debt, in an attempt to boost its liquidity and calm investors a day after the bank’s share price plummeted. ( Financial Times)

Whilst Credit Suisse is of course under Swiss jurisdiction and getting liquidity support from the Swiss National Bank it is both large ( or rather it was large) and is closely linked to its European peers. The history of bank problems is that liquidity support is only a temporary panacea as the underlying issue is invariably solvency which it only marginally helps. I have been pointing this out on social media because to my mind the 40% rally in the Credit Suisse share price at the opening looks like a classic DCB ( Dead Cat Bounce) because the real issue here is fear and sooner or later investors will get around to the idea that if 50 billion Swiss Francs are needed there must be a big problem.

If we look at Euro area banks we see that Deutsche Bank is only up 1% at 9.7 Euros as I type this. A real change would have led to a fair bit more. Overnight the ECB will have been busy checking Euro area banks exposure to Credit Suisse as well as their own risks. Maybe they are mulling the words of Christine Lagarde from the last policy meeting press conference.

We are hearing the banks, and we have good dialogues with the banks on impacts that all our measures have. Our measures have impact on interest rates, as well, in a different direction. We are attentive to that, and, of course, we are attentive to financial stability, and this is something that comes into the decision-making process that we follow.

But at that point she had put on her inflation is no longer a hump coat.

But our objective is to reduce inflation. Not just to reduce inflation; to drive it down to 2% in the medium-term.

Although she does seem to have been right about this bit.

So there will be consequences.

In ordinary times a banking crisis like this might lead to an interest-rate cut. That would be especially awkward right now.

Reducing the balance sheet

It has not only been in the arena of interest-rates that financial conditions have been tightened by the ECB.

The Governing Council today also decided on the modalities for reducing the Eurosystem’s holdings of securities under the asset purchase programme (APP). As communicated in December, the APP portfolio will decline by €15 billion per month on average from the beginning of March until the end of June 2023,

That is a bit like when we are told in the film Airplane ” I choose the wrong day to give up sniffing glue”. But there has been more.

Liquidity figures overall would look very bleak across European banks if they would have to repay all of their TLTROs today. As such one of the most interesting themes going forward will be whether the ECB can allow TLTROs to totally roll over? ( SirOfFinance)

This is one of the unintended effects which happen if you are involved in so many areas. If you give backs so much cash/liquidity as the ECB did with the TLRTOs then they come to depend on it. So if you start to change the terms to discourage this as the ECB did last year you apply pressure to the banks. It is put simply below.

TLTRO repayments had a huge effect on banks’ liquid assets ( @JanMusschoot )

That has turned out to be a Baldrick style cunning plan as banks have been under other pressures.

So watch the under card later as the ECB will no doubt be tempted to offer something to The Precious.

The economy

This is really rather awkward as there have been times when this was enough for an interest-rate cut rather than a rise.

GDP growth in the euro area and the EU: In the fourth quarter of 2022, seasonally adjusted GDP remained stable in the euro area  ( Eurostat )

Especially if we add in this.

Annual growth rate of narrower monetary aggregate M1, comprising currency in circulation and overnight deposits, decreased to -0.7% in January from 0.6% in December ( ECB)

The outright sales of past QE bond purchases should over time make the money supply numbers even weaker.

On the other side of the coin there is of course the inflation numbers.

Euro area annual inflation is expected to be 8.5% in February 2023, down from 8.6% in January according to a flash estimate from Eurostat, the statistical office of the European Union.

That rather contrasts with the present Deposit Rate of 2.5%. Also if we look at the national breakdown we see that the claims of economic convergence seem to be still taking their time. Belgium has an annual inflation rate of 5.5% but Latvia has one of 20.1%. That males a common interest-rate sound rather like this from The Lord of the Rings.

“One Ring to rule them all, One Ring to find them, One Ring to bring them all and in the darkness bind them”

Comment

We arrive at a situation where pretty much everything is in play. Not an interest-rate cut as that would be too embarrassing and also would show that they are in a state of panic. Let us look at the other choices.

Unchanged or in central banking speak a pause. The problem with this is that whilst in objective terms it stops things getting worse for the banks it comes with the implicit admittal that something is very wrong.

A 0.25% increase in interest-rates. This has the advantage of being a compromise but to my mind is perhaps the worst choice. With inflation so high raising by 0.25% is like trying to stop a tank with a peashooter and with banks plainly in trouble may push them under water anyway.

A 0.5% increase in interest-rates. This has the advantage of being what was promised and by raising interest-rates to 3% might genuinely help with inflation. The problem is that if banks are struggling another tightening might be too much.

So all of the choices are flawed. Much of this is simply caused by the fact that they raised interest-rates too late as they behaved like ostriches and said that inflation was only a “hump”. Now as they have rushed to try and catch up they have upset the banking system. Even President Lagarde may realise that it is no longer wise to boast about this.

This is why the Governing Council started a process of policy normalisation in December 2021 and raised the ECB interest rates by 300 basis points since July 2022.

To be fair she should be well equipped to deal with a disaster because she has so much experience of them. I note this week the same Argentina that she declared to be a success saw inflation rise over 100% and of course what she called “shock and awe” for Greece collapsed its economy.

The truth is that the right answer for today’s move will have been decided by what the ECB found out as it went around the banks last night. So let me leave you with three thoughts.

We were right when in previous years we suggested that the Euro area would struggle when interest-rates rose.

What happens next depends on that most intangible of things which is confidence.

There is a reason why central banks in the past chose not to pre commit on interest-rates.

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