MNI INTERVIEW: Major Instability Would Force Rate Cuts-Papadia

Central banks would be forced to cut rates in the event of more serious concerns over financial stability, even if the short-term outlook for Europe’s financial sector is not immediately worrying, the ECB’s former Director General for Market Operations Francesco Papadia told MNI.

The claim by European Central Bank President Christine Lagarde after Thursday’s 50-basis-point interest rate hike that there is no trade-off between monetary policy and financial stability was a standard denial for someone in her position, Papadia, currently senior fellow at the Bruegel thinktank in Brussels, said in an interview.

“Draghi used to say that, Yellen used to say that when she was at the Fed, and Lagarde says that now. It’s not true, but it’s the only thing they can say,” Papadia said, when asked about Lagarde’s comments. (See MNI ECB WATCH: Rates Up 50Bps With 'Ground To Cover' - Lagarde)

“What she said yesterday that liquidity support would deal with financial stability, interest rates for inflation, is true but only up to a point,” he said. “If it comes to a really serious crisis - as in the GFC - then you also have to use interest rates and then you may get into a dilemma. Yes, you can do separation, in a mild situation like the current one, but if it gets serious then you do not have this luxury.” (See MNI SOURCES: ECB Clings To 50Bp Hike Plan Amid Market Turmoil)

TENSIONS CONTAINED FOR NOW

For the moment, tensions in Europe are likely to be contained, though central banks’ response to the collapse of Silicon Valley Bank and concerns over Credit Suisse could itself feed longer-term problems, said Papadia.

"In the long run, the Fed, the SNB and maybe the ECB, are seemingly forced to do things now that could lead to moral hazard in the long run.”

The current “localised banking problem” shows little sign of feeding a bigger crisis in the sector, and even less of feeding into a eurozone sovereign debt sell-off, though Papadia noted that increasingly important non-bank financial institutions may also be hit by volatility as in the LDI episode in the UK late last year.

“The additional issue is that these NBFIs have no access to central banks. So, they are big and have no access to central banks,” he said, though he added that non-banks should be less fragile than banks, which are always a “weak link in the chain” given their business model is based on borrowing short and lending long.

Lagarde did a good communications job on Thursday, Papadia said.

“She had a clear story to tell, deriving from the discussion they had in GovCo, that the crisis is not serious enough to reconsider their intentions, but if it gets worse, they do have the tools to deal with it,” he said. “But if it gets really serious the tools will have to include interest rates.”