The ECB and the Fed stay the course despite banking turbulence

Episodes of financial instability in the U.S. banking system continue to fuel fears of a financial crisis, in view of the recent failure of First Republic Bank and its subsequent acquisition by JP Morgan with the support of the Federal Deposit Insurance Corporation (FDIC). This is the fourth institution in trouble, after Silicon Valley Bank (SVB), Silvergate and Signature, although it may not be the last, given the risk of contagion to Bank PacWest.

The situation is putting central banks between a rock and a hard place, given the current divergence between economic and financial stability. This is adding to the cumulative effect of monetary policy and the response lag, as well as uncertainty relating to the performance of risk, as MAPFRE Economics explains in a recent report.

However, the U.S. Federal Reserve (Fed) and the European Central Bank (ECB) are staying the course. The Fed continued to moderate its message at the May meeting and balance concerns between price stability and financial stability by offering a conditional pause as a starting point for upcoming decisions, but ruling out any interest rate cuts until at least 2024.

It thus decided to raise the benchmark interest rate by 25 basis points to the official range of 5.00%-5.25%, thereby “laying the groundwork for a pause in the monetary tightening cycle.” However, this remains subject to growth and inflation figures as they arise, with no commitment to a terminal rate, as MAPFRE Economic Research notes.

On the balance sheet, the Fed kept the process of reducing asset holdings unchanged, under the monthly mix of 60 billion dollars of Treasuries and 35 billion dollars of mortgage-backed securities (MBS), without offering any other forward guidance.

MAPFRE Economics notes that employment performance continues to be solid, as are activity data that confirm figures that are more positive than expected. “The latest PMI's indicated that the U.S. manufacturing sector had contracted again, while the services sector continued to expand at a more moderate pace,” it notes.

The process of inflation easing continues to provide a positive reading, although the pace of the decrease is slower than expected, with energy as the main deflationary driver in the overall reading. This is not the case, however, with core inflation, which again recorded a year-on-year increase, nor with wage growth, which continues to struggle to recover the accumulated loss in real terms

 Europe: a pause in rate hikes still a long way off

The banking turmoil in the United States has not been replicated in the Eurozone, which is showing some resilience and is now shoring up its already strict, but still incomplete, banking regulation.

Against this backdrop, the ECB also raised its benchmark rate by 25 basis points, thus placing the range of interest rates on main financing operations, marginal lending rates and the deposit facility at 3.75%, 4.00% and 3.25%, respectively.

The agency is continuing to reduce holdings of securities purchased through the asset purchase program (APP) at a pace of 15 billion euros through June 2023, but not APP reinvestments, which will be halted in July. In addition, its intention to reinvest principal payments on securities acquired under the PEPP will be maintained until at least the end of 2024.

As in the case of the United States, the inflation outlook remains “too high for too long” and, therefore, a further effort is required in terms of monetary policy, the report explains.

The baseline scenario with respect to the future monetary stance in the Eurozone remains that of maintaining the pace of interest rate increases at the current 25 basis points, at the cost of reducing the balance sheet at a faster pace. MAPFRE Economics sees this move as the most likely for the ECB meeting in June, and expects September to be a possible turning point to reach a terminal rate. Then it would be possible to assess the response lag of monetary policy with sufficient room for action to sustain positive real interest rates for a time.