Aggressive monetary tightening could send ripple effects through financial markets

Sharp increase in key policy rates as advocated by some analysts could send ripple effects through the financial markets by way of mass scale defaults, demand destruction and thus forcing people from frying pan into the fire as it will increase poverty.

The playbook of monetary policy hawks and other classical economists are to arrest inflation through tighter monetary policy, which leads to demand destruction and thereby tipping the economy into a recession.

Sharp increase in policy rates would send bank lending rates through the roof inflicting massive pain on borrowers who are already struggling with two years of the pandemic and the economic slowdown that followed.

“Massive rate hike in the scale of 500 to 750 basis points would trigger mass scale defaults, wave of business bankruptcies and thousands of job losses sending the economy into a complete tailspin,” said a banking sector analyst on the grounds of anonymity. 

On Wednesday, First Capital Research predicted the Monetary Board to deliver 500 to 750 basis points hike in key rates when the Monetary Board meets today under the leadership of the new Governor Dr. Nandalal Weerasinghe.

“The magnitude of the rate hike is preposterous and the financial sector meltdown could be inconceivable,” he added.

The lending rates are already adjusting upwards faster in response to the 150 basis points hike delivered so far this year and the adjustments have more room to run their course.

This is because there is typically a 12 to 18-month lag in the full monetary policy transmission although the cycle has been getting shortened in recent times.

Hence, the Central Bank could deliver another aggressive yet modest 100 to 200 basis points hike, according to the analyst.

The banks are already fretting about what higher rates would mean for their non-performing loans and growth.

Data shows that a percentage point increase in lending rate means 10 percent decline in the housing affordability and 20 percent increase in non-performing loans.