The sequence is clear. The change in the interest rate cycle was on the horizon at the end of 2021 and materialized in March 2022 in the US and in July of the same year in the euro zone. As inflation has resisted going down and central banks have acted late, the rise in rates is being very abrupt. We have experienced very few such cycles in the past. The consequences could not be other than a trail of business mishaps. First there were the bankruptcies of the crypto companies and, especially, the FTX scandal. Then the serious problems of Mrs. Truss and the pension funds in the United Kingdom and, throughout 2022, the sharp stock market decline of technology companies. Finally, the setback has come to banking, which, by design, is a leveraged and fragile sector.
We said a few months ago that crockery was in danger in times of moving. Now more dishes have been broken. Weak business ventures, with poor risk management and poor governance are suffering. This will probably continue to be the case for the duration of this financial tightening phase.
Inflation is more entrenched than the authorities admit and its control requires higher rates for a certain time
Authorities on both sides of the Atlantic are facing difficult decisions. They must decide whether the fight against inflation or financial stability prevail. I think that the first objective is a priority and that the risks of financial instability will remain limited.
Inflation is much more entrenched than the authorities want to admit and its control requires higher rates for a certain time. The financial restriction will also serve to eliminate excess liquidity from the system and restore the value of money and savings. Staying the course will create room for future use of monetary policy without having to resort to unorthodox debt-buying policies by central banks.
Regarding financial stability, it is likely that there will be more incidents, especially in the less regulated areas of the financial system (credit funds, private equity, hedge fund, etc…). Since regulated banking is solid in terms of capital and liquidity, it is not to be expected that the new broken dishes will turn into a crisis of the system and a general problem of mistrust. In addition, if this were to happen, if all the crockery were to break due to some hidden risk in shadow banking that was transferred to the conventional financial system, central banks have powerful intervention mechanisms at their disposal. They are the lenders of last resort that guarantee the stability of the system and, ultimately, they are backed by the governments of two solid economic zones such as the US and the Eurozone.
They are not going to be pleasant weeks or months. Nobody said it was easy to leave behind an era of free money and abundant debt. It will be complicated, but it is the path that, once completed, will lead our economies towards more balanced and sustainable growth.