A natural question to ask in the aftermath of recent banking sector woes is whether central bank interest rate policy will be affected. Financial sector tensions are contractionary and deflationary. Central banks will be concerned that banks will start to worry about depositor and investor sentiment evaporating, triggering deposit withdrawals and resulting in a surge in interest rates on bank bonds. If that were to happen, the risk of recession will rise, perhaps dramatically.
To lower the risk of such an adverse shift in sentiment, banks are likely to behave in a more conservative manner by cutting back on lending to less credit-worthy borrowers. They will also revise up their assessment of the riskiness of lending. Overall, that tightening of lending conditions will translate to there being less credit available and at a higher cost.
That, of course, may be helpful for individual banks, who naturally view their actions as having no implications for the broader economy. However, when banks act collectively in this way, the overall economy will be affected, perhaps severely. Less credit at a higher cost will slow the economy and reduce inflation pressures.
Given current high inflation rates, that will reduce the need for higher interest rates and therefore be welcomed by central banks. However, the extent it will do so depends on economy-specific factors and will therefore vary between economies. In Switzerland and the euro area, where banks are generally seen as well capitalised and safe, the banking turmoil is unlikely to lead central banks to stop raising interest rates or reverse course. They will continue to raise interest rates, although perhaps a little less than previously expected.
In the US and the UK, central banks are much more likely to change direction and start cutting interest rates, and to do so much earlier than previously expected. The graph below shows how US interest rate expectations have collapsed following the collapse of Silicon Valley Bank.