Consequences of persistent inflation and monetary policy

By Andreas Charalambous and Omiros Pissarides

With the easing of the pandemic and the gradual reactivation of economies, rising inflation was initially perceived as a transitory phenomenon. The authorities’ underestimation of the underlying dynamics of retail prices led to maintenance of a ‘loose’ monetary policy. At the same time, prolongation of the war in Ukraine led to instability and uncertainty and contributed to further increases in the prices of basic goods and fuel.

Over the past year and a half, most central banks reacted by announcing unprecedented and successive increases in key interest rates, in an attempt to tame inflation. In this context, the following conclusions can be drawn:

(a) The approach adopted aims to limit consumption by increasing the cost of borrowing. Its effectiveness, however, depends on the conditions in each individual economy and the actions of commercial banks in their capacity as ‘’agents of transmission’’ of monetary policy to the real economy. In Cyprus, for example, the comfortable banks’ liquidity position is an inhibiting factor for the adjustment and increase of deposit rates.

(b) Until recently, market expectations indicated that the ECB would continue its policy of raising interest rates for a long time, considering that the effects take about a year to filter through the real economy. Although initial data suggested that the pace of inflation was slowing, recent data indicates that prices remain elevated. The latest developments regarding American banks Silicon Valley Bank and Signature Bank, as well as the Swiss bank Credit Suisse did have an impact on markets, but did not lead to a shift in policy stance. The ECB continued its policy of raising key interest rates by 50 basis points in its recent meeting in March.

(c) Some consequences of the unprecedented rate hikes are worth noting. The collapse of Silicon Valley Bank, a US non-systemic bank with a $211 billion balance sheet, demonstrated the risk that exists when there is a time mismatch between liabilities and assets. The bank essentially invested its customers’ deposits in US treasuries and mortgage-backed securities, with the latter posting large accounting losses, following the rising interest rates and highlighting some of the monetary policy dilemmas that should be considered. The Federal Reserve appeared to appreciate the consequences and, during its meeting on Wednesday, increased interest rates by 25 basis points, as widely expected by analysts amidst the ongoing banking sector concerns.

(d) It should not be overlooked that central banks themselves are adversely affected by the higher interest they have to pay on deposits from commercial banks. In particular, the difference in interest rates on the assets and liabilities of central banks may create the need for support from their governments, with a negative impact on national budgets.

Ultimately, sharp increases in interest rates do not immediately deliver the desired result, while they are also accompanied by negative effects. It is important to closely monitor potential spill overs in the real economy, with a view to rapidly adjusting monetary policy if needed and avoiding negative repercussions on growth.

Andreas Charalambous is an economist and former director at the Ministry of Finance. Omiros Pissarides is the Managing Director of PricewaterhouseCoopers Investment Services