In last four weeks, advanced market economies led by the US showed clear signs of a banking turmoil created by deposit outflows. Financial experts attribute this to heightened interest rate risk confronted by banks consequent to rapid phase of interest rate hikes by central banks. They also alert a possible trigger of banking and financial crisis after 2008/09. Therefore, they propose central banks to suspend rate hikes immediately and permit markets to stabilize gradually.
Therefore, the objective of this short article is to present the phase of macroeconomic risks expected from present tight monetary policies and to alert policy authorities on the need for an alternative policy package to resolve such risks before they burst in the near future.
Background of interest rates hikes
The monetary policy story behind this is well articulated. Central banks commenced hiking interest rates beginning 2022 to tame rising inflation of four decades high. Present monetary policy models are driven by the policy interest rates with the price stability/low inflation as a major objective of central banks. Therefore, they do not look back until inflation is brought down to targets, i.e., 2% in advanced market economies, as they consider appropriate, irrespective of real causes of inflation and macroeconomic risks of high interest rates.
It is customary for all central banks to follow the interest rate path of advanced market economies, especially the US Fed, to prevent disruption of capital flows. Therefore, monetary policy is a simple gamble played by central banks.
The extent of rate increases so far has been about 3%-4.75% in advanced market economies. As a result, their interest rates now stand at around 3%-5% as compared to close to zero level that existed for nearly a decade after 2007/09 global financial crisis.
The rate increase by the Central Bank of Sri Lanka so far is 11%, i.e., from 5.5% to 16.5% in 6 occasions, followed in same version of advanced market economies, despite Sri Lanka being a bankrupt economy.
Inflation control power of interest rate hikes
The story is customary in monetary theory. High interest rates raise cost of credit and push brakes on credit creation. This decelerates money available for spending on goods and services and cuts down the demand in the economy. The lower demand is expected to pull down prices and inflation, given the externally determined supply.
However, central banks neither have empirical research findings on effects of interest rates on inflation outcome nor know how high interest rates get translated into lower prices and inflation in modern monetary economies with global transmission of services of money.
Therefore, inflation control story is only a concept that is followed from tribal money societies in monetary history.
Macroeconomic risks of interest rate hikes
No monetary theories are necessary to show real world risks and costs of high interest rates as they are well experienced by all segments of the economy from the government, corporates, entrepreneurs, households, fixed income earners and men on the road.
The story of downturn or recession of the economy caused by high interest rates has no debate. Even central banks expect the economy to slow down with higher rate of unemployment and lower income. This is considered as the pre-requisite to lower the demand, i.e., consumption and investment, to match the supply level of the economy. However, none has any idea of how much of recession or interest rate hike would be necessary to bring down inflation back to their targets.
The uncited risk of high interest rates is the possibility of turmoil in banking liquidity and capital that has potential of triggering a banking and financial crisis if interest rates are raised faster and kept for long time. This happens through interest rate risk generally confronts the banking business.
The clear evidence for this is the banking turmoil seen during last three weeks in the US, UK and Europe, despite the world class regulatory system. The collapse of five banks (including 17th largest bank in the US, i.e., Silicon Valley Bank and one of two largest banks in Switzerland, i.e., Credit Suisse).
Early warnings of banking crisis
The banking turmoil stated above showed several early warnings of an impending banking crisis through a liquidity crunch and a threatened-insolvency. Some of major warning were as follows.
Outflow of deposits to bigger banks and private investment markets causing liquidity problems to banks.
Gradual phase of deposit outflow by businesses and households to finance their spending due to credit crunch, high interest cost and reduced incomes which is a clear sign of liquidity problems confronted by all segments.
Erosion of market value of liquid assets, primarily long-term government securities and mortgaged-back securities in bank investment portfolios, due to high interest rates causing of liquidity problems immediately and insolvency threat in the medium-term.
Tumble of bank stock markets due to speculation of banking problems wiping out a significant value of investment.
Rising non-performing loans consequent to high interest cost and economic downturn/recession which is a major source of immediate liquidity problems and eventual insolvency threats.
Risks of asset bubble burst as usual during faster cycle of interest rates after a long period of very low interest rates which raises the level of bank non-performing loans and reduces value of loan collaterals. This was a major cause of 2007/09 global financial crisis.
In the event of a banking and financial crisis, economies will collapse globally and confront a deflationary period. Therefore, it will be inhuman for central banks to expect such kind of inflation control by high interest rates.
However, all central banks and state authorities in those countries issued abrupt public messages assuring that banking systems were sound, strong and resilient. They also commenced blaming banks for poor risk management that has caused the turmoil. In addition, the need for another round of bank regulatory overhaul to prevent such turmoil in the future was highlighted. All these are usual habits of central banks.
Sri Lankan Context
In addition to consequences of high interest rates highlighted above, Sri Lankan banking system is hammered by historic economic crisis and instability, acute shortage of foreign currency, default of govt. foreign debt since April 2022, possible concerns over restructuring of govt. domestic debt including government securities in bank liquid asset portfolios, restriction on access to overnight borrowing from the central bank and contracted inter-bank market.
Further, insider monetary dealings to manipulate exchange rates and interest rates while mobilizing markets to take visible risks of funding the government pending debt restructuring are acts outside the interest rate policy model and would further disrupt the market mechanism.
Therefore, the crunch in both liquidity and solvency confronted by banks in Sri Lanka is not a secret. In that context, the complacent and ambitious statement of the central bank that Sri Lankan banking system is sound and resilient is a grossly incorrect statement made without any knowledge of macroeconomic principles behind banking and current circumstances.
Banking turmoil is globally evident at present consequent to rapid and high interest rate hikes by central banks. Financial media reports that nearly 180 regional and small banks in the US are under liquidity stress caused by deposit outflows.
The alarming concern is the electronic contagion of depositor runs 24 hours in the present electronic banking environment before bank regulators and the public see the runs physically in old style. In present form of electronic social media, the contagion across the globe will take only few hours or days.
Therefore, abrupt statements made by central banks and regulators that respective banking systems are sound and resilient are meaningless as such statements are based on old accounting liquidity and capital ratios/calculations. In the present context of banking turmoil and risks, individual banks are highly vulnerable and, therefore, these liquidity and capital ratios can be wiped out overnight if the situation turns bad.
However, four global central banks further hiked their interest rates last week and hinted further hikes, given widespread and still untamed inflation not responsive to rates hikes so far. Those are the Fed by 0.25% to 5%, European Central Bank by 0.50% to 3.75%, Bank of England by 0.25% to 4.25% and Central Bank of Switzerland by 0.50% to 1.50%. The rest will follow suit happily in coming weeks as it is their way of life. Given, four decades high inflationary pressures across the globe, there is no expectations that central banks will commence the rate cutting cycle before end of 2024. Therefore, the probability of turning the present bank turmoil into asset bubble burst and a baking crisis is very high. If that happens, the global economy will contract causing deflationary conditions that will cause central banks to cut interest rates immediately back to around zero as generally experienced in the past. Therefore, what we need is to avoid that sort of macroeconomic risks which are highly unfair in democratic societies.
Therefore, the time has come to accept that interest rate based monetary policy arm of central banks cannot stabilize economies by taming inflation. Therefore, they have to immediately sterilize the interest rate arm and launch a policy package encompassing of both policy arms, i.e., monetary policy and bank regulatory policy, to restore both real economic stability and financial stability which have already been poisoned by high interest rates. It is common sense that real economy and financial economy are inter-dependent and inter-catering and, therefore, both policy arms must be active in close coordination.
In addition, the support of fiscal instruments is necessary to protect the public trust in the system before it fades a way in the current context because central banks have no track records of keeping economies and financial systems stable only by themselves as they are not the only game in town although they think so. If they are so capable, present inflationary pressures and banking turmoil could not have happened in front of their eyes. The fact of the matter is that central banks can protect depositors without fiscal support during bank turmoil only if they print money to bailout banks as deposits are money created in bank books under the watch of central banks.
Inflation in modern economies with access to the global economy is an economic outcome of imbalances among markets including money markets, i.e., commodity markets and factor markets, and, not a cause per se that troubles economies as central banks believe. Therefore, the control of inflation requires fixing market factors that led to inflation. As such, central bank to use interest rates as the only instrument to tame inflation and thereby to stabilize economies is a clear misconception. The history tells it. Therefore, central banks must eradicate the disconnect between the monetary arm, regulatory arm and fiscal arm in pursuit of stabilization of modern economies.
Authorities have to ensure the safety of all depositors as the current turmoil is a conscious policy default of monetary policy arm of central banks while keeping their regulatory arm asleep as usual. Information so far reveals that the Fed failed not only to detect basic interest rate risk and liquidity risk on deposits and investments in government securities of Silicon Valley Bank, 17th largest bank in the US, despite ambitious stress testing, but also to notice that the bank did not have a Chief Risk Officer for the past 9 months. It is now revealed that bank stress tests being a new comer to bank supervisory tool box, do not cover the liquidity risk scenarios. Therefore, the customary approach to resolve banking problems and instabilities only through the regulatory policy arm disconnect from the monetary policy arm is a clear misbelief. Therefore, central banks have to wake up from the habitual sleeping mode if they are to survive in the present decade of political governance system. However, the fact that both policy arms rest in two compartments of same siberia is the hudle to wake up.
Therefore, the implementation of the proposed new integrated policy approach requires all rounders in central banks who understand macroeconomic management principles behind central banking in modern monetary economies.
The same approach is the only alternative available to bankrupt countries like Sri Lanka that require a domestic bail-in as no external parties will bail out such economies operating in disrupted markets and political governance. However, tools and composition should be different from advanced market economies due to structural differences.
(This article is released in the interest of participating in the professional dialogue to find out solutions to present economic crisis confronted by the general public consequent to the global Corona pandemic, subsequent economic disruptions and shocks both local and global and policy failures.)P SamarasiriFormer Deputy Governor, Central Bank of Sri Lanka
(Former Director of Bank Supervision, Assistant Governor, Secretary to the Monetary Board and Compliance Officer of the Central Bank, Former Chairman of the Sri Lanka Accounting and Auditing Standards Board and Credit Information Bureau, Former Chairman and Vice Chairman of the Institute of Bankers of Sri Lanka, Former Member of the Securities and Exchange Commission and Insurance Regulatory Commission and the Author of 10 Economics and Banking Books and a large number of articles publish.
The author holds BA Hons in Economics from University of Colombo, MA in Economics from University of Kansas, USA, and international training exposures in economic management and financial system regulation)
Economy Forward: https://economyforward.blogspot.com/2023/03/central-bank-interest-rate-gamble-stop.html