Financial Stability Implications of Increasing Interest Rates

Abstract:

Increasing interest rates appear to pose little risk to financial stability at present. The basic reason is simple: Monetary policy normalisation, which comes as a reaction to the ‘normalisation’ of the economy, should not lead to a deterioration of the creditworthiness of most debtors.

The end of the bond-buying programme of the ECB, per se, should not pose a threat to financial stability. It has already been anticipated in the markets, and the public sector purchase programme (PSPP) seems to have had only a minor and temporary impact on yield spreads within the euro area. The remaining risks to the stability of national government bond markets appear to be mainly political.

Policy normalisation more in general, including bringing policy rates into positive territory, might have some stabilising impact on the banking system, as it would tend to improve net interest margins.

A legacy of the PSPP is that the cost of servicing government debt will be less exposed to market rates, but more directly and quickly exposed to increases in ECB policy rates. Conversely, banks would benefit more from higher revenues on the €2 thousand billion they hold in central bank deposits at present, potentially strengthening their capital position and ability to lend.

Given the limited role of the euro as a reserve currency, the global impact of normalisation by the ECB should also remain limited since it has been preceded by normalisation in the US. Pockets of vulnerability remain in emerging markets, however, especially those in the European neighbourhood with large current account deficits.

• Primary Source

• Alternative Source