To hike or not to hike?
Thinking about thinking about
Considering the current situation what are the logical constructs of the options the centrals banks have?
The big question that the market is debating right now is whether the Fed should/would hike or not at the next FOMC meeting. A similar question also is popping up for European Central Bank, who’s announcing their policy action tomorrow (March 16th, 2023). Let’s put in some thoughts regarding this question - We obviously cannot decide for them, they have probably already made their mind, but we can go through the thought process and see what options exist and how do they shape up in the current context.
Pre-Context
About a week back the answer to this question would have been relatively straightforward - Inflation is raging in Europe, and the Central Bank needs to tame it down. They needed to raise - the market appeared to be expecting a 50 basis point raise. Situation in the US was somewhat better, but not by much. US had already gone through a deep tightening process with close to a year of subsequent interest rate hiking, at a rate that has never been seen in history. In other countries, like Canada, the central bank had already indicated a pause indicating growth concerns.
Current Context
Within the last week three banks in the US failed or were closed down by regulators. There were many contributing factors, but some important ones pointing to the steep hiking of interest rates after more than a decade of very low rates, Fed’s earlier guidance of transitory inflation (and thus no major hikes required), and the some institutions inability to adjust to this fast changing monetary regime. The result was a panic that set in Main Street, in the form of bank runs the pace of which was never seen except perhaps during the Great Depression and the Great Recession, and eventually seeped into Wall Street. Over the weekend, the regulators and law-makers worked to stabilize the situation - with provisions such as unlimited coverage of deposit insurance, while letting the institutions fail, and selling off their assets.
And then on Tuesday, a news story that shouldn’t have rocked the markets did rock the markets - an investor in Credit Suisse not willing to put additional investments beyond the 10% cape siting regulatory reasoning.
What all this means is that the market is in a panicky mood. It is worried about the stability of the financial system. It is scared of a potential recession scenario.
To hike or not to hike?
Having set the pre-context and the context, let’s review this question and the options.
Option A - Hike
This allows the central bank to maintain course. It would show their resolve to keep at it till inflation is slain.
This fails to acknowledge their failure of a brewing systemic risk that over the weekend they confirmed by taking exceptional action.
Another disadvantage of hiking at this point is that, in the potential scenario of an extension of this banking crisis (be it another bank failure or destabilization of financial markets), the finger would squarely point at the central bank.
There is a sub-option here where the central bank might raise but at a rate less than originally planned.
Option B - Pause
This allows the central bank to acknowledge the change in situation and their failure in identifying a systemic risk.
This action will however, show weakness in central bank’s willingness to fight inflation. That however can be mitigated by indicating that the hike or pause questions is in fact being postponed to the next meeting to buy time to let the markets stabilize and provide them the time to assess the situation. This approach has an additional benefit of providing them an additional data-point on the inflation read.
Pausing would not necessarily be equivalent to the Volker mistake of the 1980’s of bringing interest rates down in response to an initial fall in inflation only to have inflation go back up again. Pausing can in fact be presented as a lowering of frequency of rate hikes - in history we have seen rate hike frequency set at alternate meeting hikes.
The one disadvantage of pausing is this - if there were no other way to tame inflation except to bring about a recession, pausing will delay that event, and thus will delay the onset of the next cycle.
Option C - Cut
There is no unconfined systemic risk and the inflation battle is not fully over yet. So, this option will not be logical at this point.
Conclusion
Again, how central bankers think and what they will do is beyond our purview. However, doing a logical review of the the situation, it seems we have a logical foundation of what the central banks are best positioned to do.
The European Central Bank hasn’t had an actual bank failure in its hands as yet. Yes, the markets are panicky, but the inflation fight appears to have some more stretch to go. So, unless the underlying condition has dramatically deteriorated, the central bank, I believe, is best positioned to take the path of a hike at a lower rate.
On the other hand, the Fed has had a number of actual bank failures on its hands, and at least one that they deemed as posing systemic risk. And thus they have the cover to take a pause at this time, take stock of the situation and then in the next meeting continue if need be.