Thomas Lyons 
The United States Federal Reserve (US Fed) is particularly worried about the economic implications and considered not increasing rates at all during last week’s policy meeting.
Despite this concern, the US Fed and three other major central banks have increased rates over the past two weeks. However, it appears that we are approaching the end of the rate hiking cycle, with only modest additional tightening expected in the next few months, and markets are pricing in rate cuts for later in the year.
Financial market conditions and lending standards have already tightened over the past year, and this could be exacerbated by the tensions seen in the banking system in the past fortnight. The US Fed anticipates that recent developments are likely to result in tighter credit conditions for households and businesses, leading to a negative impact on economic activity, employment, and inflation. The extent of these effects is uncertain, but Fed Chair Powell opined that they could easily have a significant macroeconomic impact.
Less confident US banks may be more reluctant to lend at the same pace as previously, and there are concerns that stresses in the banking system could lead to a credit crunch in the US. European Central Bank (ECB) President Christine Lagarde has also warned that recent tensions are not trivial and will have repercussions, noting that the euro area economy could face a less favourable economic environment due to lower growth, weaker loan demand, and higher bank funding costs.
Higher interest rates could continue to expose underlying financial vulnerabilities, with potential for rising loan defaults, particularly in weaker low-income countries, where signs of debt distress are increasingly evident. However, central banks have noted that the banking system remains strong in terms of its capital and liquidity positions, and broader financial contagion from recent events has been limited thus far.
The rapid withdrawal of very loose monetary conditions that were in place for the previous decade was always likely to cause problems in parts of the financial system as mismanagement and bad investment decisions were exposed when rates rose. Central banks are now faced with the difficult task of bringing down inflation, maintaining financial stability, and avoiding excessive damage to the real economy.
Recent events are likely to have a deflationary impact on economies, as oil and gas prices have fallen further and are now well below the levels that prevailed ahead of the Russian invasion of Ukraine. Global food commodity prices are also continuing to fall, and forecasts of 3% CPI rates by the end of the year are becoming more common, with expectations of further falls in inflation in 2024. An improving inflation outlook, as well as the likely negative impact on activity from recent financial events, supports the much lower trajectory for interest rates evident in the past fortnight.
In summary, the stresses in the global banking system are causing concerns for central banks, with tighter credit conditions for households and businesses and potential rising loan defaults. The deflationary impact on economies is likely to support lower interest rates, and central banks face the challenge of bringing down inflation while maintaining financial stability and avoiding excessive damage to the real economy.
