The Strategist

Dual challenge

Given the turmoil in the banking sector, central banks seem to be confronted with a dual challenge. While the fight against inflation remains the primary goal, the rate hike cycle is starting to show signs of fracturing. Therefore, the risk of an escalation of the banking crisis could play a decisive role in the Fed's interest rate decision.

Thomas Wille
Reading time
10 minutes
Dual Mandate
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Price stability is usually the primary objective of major central banks. However, the Federal Reserve is one of the few monetary watchdogs already with a dual mandate that includes securing price stability as well as full employment. However, due to the recent turmoil in the banking sector on both sides of the Atlantic, a new dual mandate now seems to be emerging. In addition to the Fed's familiar 2% inflation target and the labor market, maintaining the stability of the financial system is now coming increasingly to the fore as a second important objective.

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At what cost?

In the fight against inflation, central banks must play it safe and not show any weaknesses. Undoubtably fighting inflation remains the primary objective, but in recent days the question has increasingly arisen as to what the consequences of the fastest rate hike cycle in the United States and the eurozone are and what price the Fed and the ECB are prepared to accept for this. It is not only the speed of monetary tightening that matters, but also the fact that rates have been raised from a zero or a low-interest rate environment. The first cracks in the system have now already become visible as US regional banks such as Silicon Valley Bank (SVB) or First Republic Bank (FRB) have impressively demonstrated. Against this backdrop, it became clear last week that the two most important central banks have been given another mandate. Also, with the failure of Credit Suisse - seen as systemically important - it quickly became clear that, in addition to fighting inflation, stabilizing the financial system is now a top priority for central banks.

Determined central banks

In the face of the looming banking crisis, the Federal Reserve, in coordination with other weighty central banks, did not hesitate for long and calmed the financial markets with ample liquidity. Last week, for example, more than 150 billion US dollar was pumped into the market via a discount window led by the Fed. This stimulus was larger than during both the Covid-19 pandemic and the great financial crisis of 2008/2009. Together with other liquidity injections, the Fed's balance sheet grew by more than 300 billion US dollar last week.

No classic QE

Even though the Fed has expanded the balance sheet again in the short term, this cannot be compared with classic QE (quantitative easing). During the period of the great financial crisis up to the corona pandemic (2008-2019), the expansion of the central bank balance sheet was characterized by a classic "asset swap" that primarily affected financial portfolios. The impact on the real economy, and thus on growth and inflation, was very limited. Now, however, balance sheet expansion is primarily about eliminating liquidity bottlenecks at commercial banks that have run into difficulties due to inadequate "asset-liability management" of their balance sheets.

All eyes on the Fed

After the ECB's latest rate hike, all eyes are on the decision of the Federal Open Market Committee (FOMC) tonight (8 p.m. CET). In our view, the decisive factor will be how Fed Chairman Jerome Powell will comment on the next rate hike - the market consensus anticipates another 25 basis points. In the process, financial markets will also listen closely to what the Fed's next steps might be in a potential further escalation of the banking crisis. In this scenario, we stick to our defensive strategy, with a relative preference for bonds over equities.

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