Pursuing price and financial stability

02/12/2022

Pursuing price and financial stability

Prof. Edward Scicluna, Governor of the Central Bank of Malta addressed the guests at the Institute of Financial Services Malta's annual dinner.

In his speech, the Governor made reference to how the economic scenario changed since the last annual dinner took place when economies were gradually re-opening after the havoc brought about by the COVID-19 pandemic and when policy rates in the main advanced economies were still negative or mildly positive and inflation was also expected to go back to moderate levels.

Unfortunately, the war in Ukraine has amplified shortages of certain commodities and unleashed an unprecedented energy shock which has disproportionately affected Europe. The rate of inflation reached two-digit territory for the first time in decades.

Inflation has also remained on an upward trajectory in Malta, despite the generous subsidies which kept wholesale and retail fuel and electricity prices at 2019 levels. Food inflation has been only moderately below that in the euro area while non-energy industrial goods (NEIG) and services inflation have exceeded the corresponding euro area averages. In particular, services inflation in Malta averaged 5.8% since January, far above the rate of 3.4% recorded for the euro area.

Nevertheless, while domestic economic activity can be expected to gradually slow down during the current and coming quarters, the European Commission forecasts that Malta is still expected to have the second highest rate of growth in the euro area, while the unemployment rate is still below the lowest rate recorded pre-pandemic.

As regards monetary policy, interest rates are expected to be the main tool to achieve our objective of anchoring inflationary expectations close to 2% rate but normalisation needs to be complemented with balance sheet normalisation. The latest rate hikes by will continue to be complemented with a reduction in the Eurosystem's monetary asset holdings. This will undoubtedly change the financing environment which borrowers have grown accustomed to with the most immediate impact will be on money markets and government bond yields, which later propagate to the cost of bank and corporate debt. While in Malta the transmission of the latest monetary impulses to bank lending and deposit rates appears rather slow, government bond yields in Malta have already begun to increase. Such increases and tighter financing conditions abroad will eventually be reflected in a higher cost of funding for domestic banks, and eventually, households and corporates.

The transmission of tighter monetary conditions to the interest rates that banks offer to their customers is necessary for inflation to return to the policy target of 2% in a timely manner. But policy actors also need to do their part, in particular, fiscal support which has to be temporary and targeted, so that it avoids supporting demand for longer than is necessary.

Turning to financial stability and macroprudential policy, the Governor said that as macroprudential authorities, we need to ensure that our banking systems are resilient in the face of risk materialisation, which remains elevated in the euro area. The macroprudential authorities must remain true to their primary objective - to ensure financial stability, just as monetary authorities need to remain loyal to price stability.

Like their counterparts in the euro area, the banks have strengthened their balance sheets and capital positions in recent years, and this ensures that the sector is well-prepared to adapt to risks as, and when, they materialise. The Bank's stress tests also confirm that capital remains above regulatory requirements even under extreme scenarios, and that banks are operating with healthy liquidity buffers while profitability is also improving. Therefore it is opportune to strengthen capital buffers rather than to have to re-build them in a potentially less benign environment at some point in the future.

Prof. Scicluna ended his address on a positive note by saying that in November, inflation across most Eurozone countries including Malta has taken the first drop in seventeen months and that the much expected recession at the end of this year might not materialise after all. He concluded that "the ECB will no longer continue raising interest rates.? Well ....not quite".

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