Caught between the devil and the deep sea

Interest rates are being hiked in an unrelenting manner by all the major central banks of the world (Fed, ECB, Bank of England) to combat decade-high inflation rates. This is being followed by central banks in most other countries. Yet, inflation has remained stubborn.

Interest rate hikes have several anticipated economic consequences, like making loan-financed consumption and investment expenditures more costly, thereby cutting down aggregate demand. The exact division of the impact of lower demand on inflation and growth depends on several factors, such as sectoral capacity constraints, supply chain and transportation disruptions (due to Covid and continuing Ukraine war), tightness of labour markets, and inflationary expectations.

That is why, in many countries, interest rate hikes are not bringing inflation down, though GDP growth is being adversely affected. The cost of financing budget deficits by governments and loan servicing by both public and private sectors is also going up as a result of aggressive rate hikes.

Unlike FDI flows (which depend mainly on the expected future growth and profit prospects in different countries), foreign portfolio investments are sensitive to interest rate differentials (adjusted for exchange rate risks), which forces central banks in emerging economies (such as RBI in India) to move interest rates in tandem with the US Fed and the ECB to discourage capital outflows. Capital outflows cause a fall in the value of the domestic currency, which pushes up inflation by making imported goods (including oil, machinery, components) more expensive, making the job of inflation control that much more difficult.

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Along with these relatively predictable consequences, a new element has recently entered the picture. This is the impact of unexpected steep interest rate hikes on the prospect of bank failures. When interest rates were extraordinarily low (near zero in the US) and inflation was also below 2% for a long time, the banks thought it would remain so for the foreseeable future.

Consequently, some banks parked their surplus funds in long-term securities (including safe government bonds) and loans at the prevailing low interest rates. The bank deposits were secured at even lower interest rates, which enabled them to earn profits from the spread between borrowing and lending rates. But as interest rates shot up to record highs very quickly, it caused a steep fall in the market value of the banks’ loan portfolios (assets of banks).

It is a basic lesson of economics that the price of low-interest bonds falls as new bonds with higher interest rate become available. As soon as depositors became aware of the fast-deteriorating health of the banks, a rush to withdraw their money (specially by non-insured big depositors) followed. The banks were not able to meet these withdrawal demands (liabilities of banks) as the highly depleted sale value of long-term assets was not enough, leading to bank failure.

In other words, in the prevailing low-interest atmosphere, the banks ignored two major risks – interest rate risk and the maturity mismatch between assets and liabilities. The banks would have been able to adjust to these risks better if the rate hikes took place more gradually over a long stretch of time. But the central banks were under immense pressure to hike rates quickly and by large doses to combat inflation.  Acting slowly entailed the danger of inflationary expectations getting entrenched at much higher levels, which then would require the central banks to raise rates even further, risking a major recession. This is particularly so as monetary policy works with considerable lag. Today’s action produces its full impact only after some time. So, central banks need to act early.

The failure of San Francisco-based Silicon Valley Bank has been followed by the bankruptcy of New York-based Signature Bank. In Europe, the Credit Suisse in Switzerland had reached the brink when the Swiss government intervened to rescue it through a takeover by UBS. Germany’s Deutsch Bank is also under severe pressure. Though the troubles of specific banks had other contributory factors, the immediate trigger in all these cases was the unanticipated interest rate hikes.

Apart from the central banks opening emergency credit facilities to provide liquidity to the beleaguered banks, the regulators are giving guarantee that all the depositors’ money would be returned. Banks survive on the trust of the depositors. Without this trust, there would be many more runs on banks and bank failures. It is not clear how many more banks all over the globe are under similar stress.

Emergency loans from central banks at the prevailing high interest rate may alleviate the immediate liquidity problem, but it would not resolve the basic underlying issue of low-interest earnings from past long-term investments of banks and the high-interest cost of banks’ new borrowing from the central bank as well as new deposits. So, the regulators are also trying hard to find bigger and healthier banks to buy up the shares of the troubled banks.

Thus, right now, the US Fed and several other major central banks are facing a new dilemma. The previous (standard) trade-off (known as ‘Phillips Curve’ in macroeconomics) was between less inflation (by raising interest rates) and more unemployment. In the new scenario, the central banks’ major policy concern is whether to go in for further interest rate hikes to control inflation or freeze/reduce interest rates to prevent more bank failures. Continuing with the first option runs the risk of triggering more bankruptcies and a major financial crisis. The second option will mean postponing the fight against inflation but only at the cost of  a much higher rate of inflation (as inflationary expectations get anchored at higher levels) in future, which would be even more difficult to control without generating a bigger recession.

From the latest moves, it seems that at this time, the US Fed, the ECB and the BoE are all considering inflation control to be their number one priority and would follow the path of interest rate hikes, perhaps  with lower doses, while tackling resultant banking sector issues by other means. At the same time, banking troubles leading to credit tightening would hopefully ease the need to raise policy interest rates as the underlying inflationary pressures will subside to some extent.

All considered, a hard time ahead for central bankers, indeed!

(The writer is a former Professor of Economics, IIM, Calcutta, India and Cornell University)