21 March 2023: Can the BoE afford to hike?

The current situation in the banking sector is such that the Bank of England will need to consider its options very carefully when it meets tomorrow to decide about whether or not to raise short term interest rates.

David Blanchflower, a member of the Monetary Policy Committee during the 2008 financial crisis, believes that the Bank should consider radical action at this week’s meeting in order to get ahead of the issue.

While the markets see either a further hike taking the base rate to 4.25%, Blanchflower believes that a cut of around 1.5% would send a positive signal that the Central Bank is not prepared to passively wait for the situation to escalate before taking action.

He also believes that the sale of bonds that were purchased during the coronavirus pandemic should also be reversed to boost money supply. This so-called quantitative tightening would increase the size of the Bank’s balance sheet again, but during a time of crisis it needs to be as proactive as possible to boost the markets’ confidence.

He labelled the the current action in which the Bank plans to reduce its holdings of bonds by eighty billion pounds over a twelve-month period as lacking imagination. The Bank has few tools with which to affect money supply, and it is not making use of this one.

The makeup of the MPC is such that only the independent members are considering the medium to long-term consequences of its actions. Swati Dhingra and Silvana Tenreyro have voted against hikes since rates were at 3.25% in November. While they were unaware of the crisis that was beginning to unfold, their actions show a degree of imagination.

The third independent member, Catherine, has been more hawkish than her colleagues recently, voting for successive fifty point hikes. It will be interesting to see if she tempers her view in light of the current situation.

With inflation falling naturally, the February figure for CPI showed that the fall in the headline figure was greater than expected, the Bank has a little wiggle room to allow it to take action and still contribute to a fall to around 3% this year.

The financial markets are currently being driven by fears of contagion, which is seeing a rise in risk appetite. Yesterday, Sterling rallied to a high of 1.2285, closing at 1.2278 as traders showed concern about how many other financial institutions are suffering from a liquidity crunch.

It is interesting to note the degree of conflict being created by the Federal Reserve’s dual role as both arbiter of regulation of the banking system and also its responsibility for monetary policy.

The latest meeting of the FOMC, which begins today, would in normal circumstances be expected to decide between a hike of twenty-five basis points, in line with the last meeting or a return to fifty point hikes in reaction to the last two months employment report which have shown that the market remains red-hot.

Jerome Powell has come in for some significant criticism recently, not least from his nemesis Margaret Warren. He is suffering from the hole that has been left by the departure of Fed Governor Lael Brainard, who recently left the Fed to take up a new role as Director of the National Economic Council.

The move was intended to broaden her breadth of knowledge, as she remains the favourite to replace Powell as Fed Chairman at the end of his currency tenure.

During ten years as a Fed Governor, Brainard constantly argued for tighter regulation of banks. This brought her into direct conflict with former President Trump, despite which she was made Deputy Chairman of the Central bank last May.

Brainard warned that a crisis of the magnitude that is currently in danger of swamping the country’s recovery was a significant danger, as regulation was being eased.

While the regulatory environment has played a part in the collapse of Silicon Valley Bank, the significant tightening of monetary policy that has been taking place over the last year has also played a part.

In an environment where regulation is being decreased, when an event happens where loosening of regulation may be to blame, politicians will always expect the Central bank to carry the can.

The fear in the financial markets is that they are unsure how much a liquidity crunch will drive further problems. While the dollar retains its safe haven status, which is not in any way in question, the fear is that if a bank the size of Credit Suisse, succumbs could the major money centre banks in the U.S. face similar issues?

The dollar fell to a low of 103.27 yesterday, and closed at 103.29. It remains within its broad range as the market awaits the outcome of the FOMC meeting.

If the Central Bank decides not to hike rates, it may be a double-edged sword. On the one hand, they may feel that inflation will fall in the coming months as demand slows, but it may also be seen as an acknowledgement that the liquidity squeeze is more serious than it is admitting.

The Swiss National Bank came in for criticism yesterday from both the ECB and the Bank of England for expecting holders of Credit Suisse bonds to suffer losses as the bank was taken over by UBS.

The Swiss Central Bank has always been pragmatic in its outlook and in this situation has adopted a stance of buyer beware.

This may come back to bite them, as there is certain to be litigation in which the Swiss regulator must take some of the blame for not being aware of the parlous liquidity situation in which Credit Suisse found itself.

There will also be some mud slung in the direction of the ratings agencies, who appear to have been blissfully unaware of the rapid deterioration of Credit Suisse’ capital position which led banks to withdraw lines of credit last week.

The ECB would do well to consider its wider role in the regulation of financial markets within the Eurozone in order to avoid contagion spreading. While it is determined to defeat inflation by tightening monetary policy significantly, it may too want to reconsider the shrinking of its own balance sheet, which is sucking liquidity from the market.

The ECB and to a large extent the European Commission have a history of dealing with crises as they occur and are let to learn the lessons of the 2008 financial crisis which, but for the determination of Mario Draghi, the President of the ECB, could have led to the demise of the entire project.

Christine Lagarde wants to separate liquidity from the fight against inflation, in line with the wishes of the more hawkish members of the Governing Council.

It is now becoming clear that the time it has taken for the Central Bank to raise rates sufficiently for them to become restrictive upon demand has meant that the ECB is ill prepared for the next crisis that is evolving.

The next few weeks will be a test for the regulations that the ECB has put in place. It has been seen as being a little soft on banks who have scraped by, only just passing stress tests.

It may be that there may be some skeletons in a few cupboards that are now in danger of being exposed.

If the ECB manages the liquidity issues that banks are bound to face and still manages to bring inflation under control, the markets will be able to breathe a huge sigh of relief.

The Euro attracted some buyers yesterday, which took it to a high of 1.0730, close to challenging its short term top. It closed at 1.0720 and is unlikely to break the resistance at around 1.0740 ahead of the FOMC meeting.

Have a great day!