- A credit crisis has been averted, but we might see a credit squeeze
- Tighter financial conditions could reduce the need for further interest rate hikes
When central banks raise interest rates, they want financial conditions to tighten. Only perhaps not quite like this.
As the fallout from Silicon Valley Bank’s collapse rocked markets last month, the Bank of England’s monetary policy committee (MPC) said that it would keep a close eye on “any effects on the credit conditions faced by households and businesses”, but that it judged the UK banking system to be both “resilient” and “well placed to continue supporting the economy in a wide range of economic scenarios”. We should avoid a credit crunch – but a more modest credit squeeze seems inevitable.
Crucially, only the first £85,000 of household and business deposits are protected by the Financial Services Compensation Scheme in the UK. There is a chance that depositors could be feeling jittery in the aftermath of SVB’s collapse as a result. Economists at Pantheon Macroeconomics expect firms to shift money into short-dated gilts (which effectively offer a 100 per cent government guarantee), and think that wealthier households could make a similar move towards Treasury-backed NS&I accounts for better protection.
As a result, banks may hike their lending rates, which would let them offer depositors a better return and shrink their loan books. The latter should allow them to hold more cash in reserve should they face an unexpected uptick in requests from depositors for their money back. Economists at Pantheon Macroeconomics said that while “the banking sector is not in crisis”, it is “enduring a funding squeeze, which will ripple through the economy via slightly higher interest rates”.
A similar mechanism could play out across the pond. Barclays analysts expect regional banks to increase rates on their deposits and pass these increased funding costs on through higher loan rates. Separate analysis from Goldman Sachs suggests that tighter lending standards could impose a 0.25-0.5 percentage point drag on gross domestic product (GDP) growth, similar to the impact of a 25-50bps tightening of their financial conditions index, or a 25bps- 50bps Fed rate hike.
But the whole idea of “financial conditions” is rather nebulous. The Bank of England’s (BoE) definition is “the ease with which finance can be accessed by firms and households”, something impacted by changes in monetary policy, but also by investors’ risk appetite and the creditworthiness of borrowers. The BoE warns that this is an “imprecise economic concept” that can not be measured directly or summarised using a single indicator – although economists give it a try. Goldman Sachs uses its own measure (as do other institutions), while the BoE favours its Monetary and Financial Conditions Index, which includes metrics such as the value of sterling, 10-year gilt yields and the performance of the FTSE All-Share.
Tighter financial conditions are one of the key transmission channels for higher interest rates: in a best-case scenario, a financial conditions squeeze could accelerate the policy tightening already under way. But a worse scenario would see a far more disorderly credit crunch, which could force central banks to make a sharp policy about-turn in response.
In March, central bankers in the UK, US and euro area unveiled a trio of “dovish hikes”: raising rates while softening suggestions that there could be more to come. After the meetings, Barclays analysts said that “tighter lending conditions will improve the Fed’s traction”, and added that they see tighter US financial conditions as “an intensification of standard monetary policy transmission mechanisms”. Bank of America analysts added that credit and financial conditions look set to become an “increasingly important part of the reaction function” for the BoE and other central banks. But ideas differ about what might come next.
Following the latest rate-setting meeting, Bob Schwartz, senior economist at Oxford Economics described the gap between where the Fed expects rates to be at year-end and what the futures market is pricing in as “astonishingly wide”. According to the CME Fedwatch tool, traders expected the Fed to hold rates steady at their May meeting, while Fed projections imply that rates still have further to go. In the UK, market pricing indicated that interest rates could rise again by 25 bps in the next meeting, although there is little consensus from economists about the longer term (see chart). Even in the absence of any further market aftershocks, it is going to take time for the dust to settle.
