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Despite the market turmoil in recent days, the ECB decided to stay the course at its March meeting, going ahead with a pre-announced hike of 50 basis points. This is clearly designed to signal the central bank’s confidence in its ability to deal with financial stability issues, while at the same time not taking its eyes off the price stability objective. In its statement, the ECB also dropped forward guidance, now stressing the importance of a “data-dependent approach” and signalling its readiness to “respond as necessary to preserve price stability and financial stability in the euro area”.
ECB President Christine Lagarde pointed to the three “brand new” components of the Bank’s reaction function, which include inflation outlook, underlying inflation dynamics, and strength of monetary policy transmission. She also suggested there was no trade-off between price stability and financial stability, which we find somewhat puzzling given the role of financial conditions in transmitting monetary policy to the real economy. Overall, Lagarde's tone was unexpectedly hawkish, stressing that if its baseline scenario persists the ECB would have much more ground to cover in its inflation fight - a big ‘if’ in light of the ongoing market stress.
By committing to this hike almost unconditionally, the ECB has put itself in an extremely tight spot - unnecessarily so in our view - leaving little room for manoeuvre in case of a shock. What is clear to us now is that banking sector flare-ups such as those seen with SVB and Credit Suisse, while concentrated in what may well be idiosyncratic stories themselves, are nevertheless a symptom of the much tighter policy environment engineered by central banks in the last few months. We have been of the view that the extent of policy tightening by the ECB and the Fed to date has already been sufficient to cause a hard landing. Both central banks must tread very carefully from here.
The latest ECB bank lending survey for Q1 2023 already showed significant tightening in credit conditions and weaker demand for loans. We now think the banking sector vulnerabilities that have come to the surface are likely to have a direct impact on banks’ willingness to provide credit, leading to even tighter financing conditions which in turn could hit the real economy earlier and harder than expected. In this respect, further rate hikes would probably be a policy mistake, ultimately requiring a rapid correction in coming months. We will be watching bank credit default swaps closely from here as the main indicator of tighter financing conditions.