Raising interest rates in periods of increasing financial stress

Published on 21 March 2023

The European Central Bank doesn’t shy away from raising interest rates amidst financial turbulence. Should the Bank of England follow suit? Professor Costas Milas writes that raising rates is not necessary. He says that the current negative growth in the UK’s divisia money supply and rising financial stress will put downward pressure on prices and suppress GDP growth.

During the recent pandemic we were told, in sharp contrast to the 2008 financial crisis, that banks were part of the solution rather than the problem. Yet, the collapse of Silicon Valley Bank followed by Flagstar Bank stepping in to buy most of the operations of Signature Bank and UBS stepping in to rescue rival Credit Suisse has brought back memories of the 2008 financial crisis.

Does it then make sense to increase interest rates when financial market turbulence is on the rise? The European Central Bank (ECB) appears to think so. Indeed, it raised interest rates in March 2023 by another 0.5 percentage points on the grounds that its main priority is to fight inflation. The ECB also appeared reassured that European banks have strong capital adequacy to withstand a banking crisis, which is also the case for UK banks based on recent “stress tests“. Contrast this with the US, however, where banking regulation appears less strict since 2018, which has arguably made mid-sized banks like Silicon Valley Bank more vulnerable.

Should the Fed and the Bank of England also proceed with further interest rate hikes to fight stubbornly high inflation? The broader question, of course, is whether central banks should raise interest rates in the presence of elevated financial market stress.

Whatever the answer to these questions might be, one thing seems certain to me. The economic profession has learnt some lessons since the 2008 financial crisis. Indeed, the financial crisis of 2008 triggered a lively debate among policymakers and the economic profession on what went wrong with their forecasting ability. For instance, the president of the Federal Reserve Bank of Boston, Eric Rosengren, noted in 2010 that the crisis was underestimated because financial links to the real economy were “only crudely incorporated into most macroeconomic modelling”. Also the head of the Monetary and Economic Department at the Bank of International Settlements, Claudio Borio, noted in 2012 that “financial factors in general progressively disappeared from macroeconomists’ radar screen” for most of the post-war period.

Financial economists and policymakers took seriously into account the above comments. For instance, Bank of England staff make the point that the bank’s forecasting platform has incorporated quantitative easing policies in the bank’s empirical models. Colleagues and I showed that an empirical model, which distinguishes between illiquid and liquid stock market conditions in the UK, is able to out-perform the GDP growth forecasts produced by the bank’s Monetary Policy Committee (MPC). In addition, colleagues and I showed that rising financial stress suppresses UK GDP growth for up to 20 months but also reduces divisia M4 money supply in the economy (note: divisia money weights component assets of money in accordance with their usefulness in making transactions). Divisia M4 money growth in the UK economy has turned negative for the first time since the 2008 financial crisis. So, one has to question whether further interest rates are necessary. This is because the reduction in divisia money, which started before the financial turbulence of the last few days, will definitely put downward pressure on UK inflation, in addition to suppressing UK GDP growth. Add to this academic research by ECB staff members showing that an unexpected worsening of conditions in financial markets causes a decline both in output and prices, and we conclude that further interest rate rises, for the time being, are not necessary!

Let us have a look at current financial stress indicators in more detail. The ECB compiles such indicators for Eurozone countries, the US, and the UK. These indicators include market-based financial stress measures that are split equally into five categories, namely the financial intermediaries sector, money markets, equity markets, bond markets and foreign exchange markets. In light of the failure of Silicon Valley Bank and the difficulties Credit Suisse is currently facing, among others, financial stress measures in the US, the UK, and Germany are elevated (see Figures 1 to 3).

Figure 1. Financial stress – UK

This article is republished from blogs.lse.ac.uk. Read the original article here.