“Central bank independence against the background of higher interest rates and financial stability: ceteris paribus or mutatis mutandis?”

Date:  9 February 2024
Speaker: Olaf Sleijpen
Location: Conference for the governors of the IMF constituency on ‘Central Bank Independence in a Changing World’, Brussels

Dear colleagues.

One of the more fascinating concepts covered in economics courses is ‘ceteris paribus’ – Latin for ‘all other things being equal’. This concept allows us to investigate the causal and independent relationship between two variables, while all other variables remain unchanged. For instance, the relationship between interest rates and inflation.

And so, ‘ceteris paribus’ offers a very simplified way to illustrate the core workings of a central bank. Or in central bank Latin, all other things considered equal, raising interest rates will lower inflation. And so, in theory, it is pretty straightforward how our primary policy tool helps to reach our primary objective – an inflation rate of around two percent in the medium term.

This kind of central bank independence – the ‘ceteris paribus’ kind – does not exist outside the realm of theory, of course. The real world – the world central banks actually work in – is instead characterised by ‘mutatis mutandis’. Meaning that changing one variable will affect several others, and not per se only the one you wanted to affect. And meaning that this works both ways. And with a multitude of variables simultaneously. Hence, to achieve our primary objective, we are dependent on an ever-changing world. Sometimes things go well. At other times, risks arise that we need to carefully monitor.

Recent history illustrates this. When eurozone inflation suddenly spiked, reaching its peak in 2022, we witnessed an unparalleled reaction from the European Central Bank. Never before had the ECB raised interest rates so fast. In a bit more than a year, the deposit facility rate increased from -0.5 percent to 4 percent. Currently, eurozone inflation has come down significantly. But with a eurozone inflation rate considerably above 2.0 percent, we are still off-target.

By the way, in the Netherlands, the ECB measures were hardly the subject of debate. The general public agreed that interest rates needed to go up to tackle inflation. What the public debate did focus on, however, was whether or not central banks reacted in a timely fashion to bring down inflation – and what role central banks themselves played in creating these price surges in the first place.

But coming back to the current eurozone inflation: one could say, looking through a ‘ceteris paribus’ lens, that central banks are successfully using their primary policy tool – they are raising the interest rate and inflation is falling. But looking through a ‘mutatis mutandis’ lens, things are less clear cut. Because these measures have also affected a number of other areas in our economies. In particular, we also need to monitor any potential financial stability risks, unintended as they may be.

I would like to highlight two such risks. The first one being household and corporate debt sustainability. The intended effect of interest rate increases is to reduce consumption, and hence inflation. But there is also an unintended effect. Which is that with every interest rate increase, debt sustainability comes under pressure. And that could have negative effects on the financial system and the real economy. And with the Dutch having the highest household debts in the EU, 88.8 percent of GDP in the third quarter of 2023 (including mortgages), we are facing a potential financial stability risk.

Luckily, most households have substantial savings, although mostly in the form of illiquid pension accounts. And, also luckily, most mortgages have long-term fixed interest rates. Only around six percent will need to renegotiate their mortgage rates in the coming year. The average fixed interest-rate period of Dutch mortgages is more than 17 years; and only around six percent of mortgages have a fully variable rate.

The story is different for corporates. Around 34 percent of them will need to renegotiate the interest rates on their loans next year – and these new interest rates will likely be higher than the current ones.

Also, the non-financial corporate sector is relatively leveraged – 121 percent of GDP in the third quarter of 2023 to be precise. This is far above the EU average of approximately 96 percent. This leverage makes them more susceptible to higher interest rates. And so, we do see financial stability risks.

So far, these higher interest expenditures have not led to a widespread inability to repay debt and interest rate. Insolvencies of corporates have gone up, but their number is more or less back at the pre-covid level after having been much lower in the previous years. Although the credit quality of loans is deteriorating somewhat, we have not seen any significant increase in the number of non-performing loans.

Still, in order to mitigate financial stability risks, we did two things. First, we increased our Countercyclical Capital buffer (CCyB) for banks to two per cent, effective this year in May. Second, in January 2022, we introduced a floor for risk weights of residential mortgages, in line with the implementation of the Basel III requirements. So far, so good. But I urge caution.

And that brings me to the second financial stability risk I wanted to highlight – the direct impact of rising interest rates on banks.

In theory, you would not expect this to be a financial stability risk because higher interest rates generally lead to higher profits for financial institutions. In the case of banks, higher interest rates contribute to a rise in net interest income, because banks can increase their margins between the interest they receive on their assets and the interest they pay on their funding.

In reality, it could prove to be a rather bumpy ride, because credit risk rises when households and non-financial corporates have troubles fully repaying their debt and interest rates. This negatively affects bank profitability.

We witnessed just how bumpy, or even financially fatal, it can be on the other side of the Atlantic. Where Silicon Valley Bank went bankrupt – mostly due to the rising interest rates.

SVB failed to hedge interest rate risk sufficiently. And so, as interest rates rose, the value of their supposedly safe assets plummeted. This resulted in negative feedback loops and ended with an old-school bank run – the speed of which had never been seen before, due to social media.

The ensuing ripple effect throughout the global financial system required enhanced monitoring of financial stability risks and policy action.

In the EU, the bumpy ride towards profitability soon aligned with a more or less textbook, ‘ceteris paribus’ scenario. That is, higher interest rates led to far higher banking profitability without the materialisation of systemic risks. So far.

But however ‘ceteris paribus’ this proved to be, the ensuing public outrage about the perceived low interest rates on savings account and corresponding high bank profits, together with the political response to this outrage, very much underscored the ‘mutatis mutandis’ reality of central bank measures. For example, we have seen an increase in new bank taxes in the EU, mostly geared towards the recent high bank profits.

Although interest rates on deposits in the Netherlands adjusted quicker to the new interest-rate environment than in most other euro area countries, a parliamentary response to the high profits nevertheless ensued. And so, the Netherlands also faced an increase in the existing bank tax.

Out of concern for financial stability risks, DNB, in its role as an independent advisor to the government, pleaded for a cautious approach if the government were to go forward with the bank tax. The decision to levy additional tax on banks is, of course, up to politicians. But from a prudential perspective, it is desirable that the design of an additional bank tax does not undermine the banks’ resilience and is consistent with its objective. In particular, a permanent tax increase may impact banks’ future ability to build further buffers. Ultimately, a bank tax could loop back to central banks by increasing the risk of financial instability, thereby jeopardising the very aim of monetary policy.

At DNB, our plea for caution, was, of course, not helped by our own projected losses – as they were regarded as the result of a substantial subsidy to the banking sector.

I’m wrapping up.

By highlighting several financial stability risks, I wanted to illustrate how central banks’ measures to safeguard price stability interact on various levels with various stakeholders - be it households or corporates, the general public or our governments. And so, I wanted to highlight how dependent we are on how and to what extent these stakeholders react to our measures to keep inflation around two percent in the medium term.

Nevertheless, however much we depend on any number of stakeholders to succeed in our work, our working methods are independent. By law. We have a legal mandate, or better, an obligation, to safeguard price stability. And to do so, we are permitted to apply our policy tools how and to the extent we, and only we, deem necessary.

But however easily I say these words today, however logical this may seem, this kind of central bank independence was, for a long time, not a given. And it may be called into question again, if it has not been challenged already in some parts of our societies.

Especially in times like these – with high inflation, public debate on saving rates and bank profitability, and bank taxes, especially in these times, we mustn’t just safeguard price stability, we must also listen to and engage with the public. And we must be fully transparent about why we do what we do, ready to account for any measure we take. Continuously asking ourselves: are we doing the right things? And are we doing these things well?

This is the best way to ensure that central banks get the job done in a ‘mutatis mutandis’ reality, but that our jobs are considered ‘ceteris paribus’ – that central banks can continue to independently safeguard price stability.

Thank you.