The European Central Bank faces an “unenviable choice” on interest rates amid banking problems

London CNN —

Just 24 hours ago, the European Central Bank (ECB) was widely expected to hike interest rates by half a percentage point on Thursday in a bid to fight inflation. But Wednesday’s market turmoil could force a rethink.

Banking stocks sold off sharply on Wednesday as concerns about the resilience of the sector spread beyond the United States following the sinking of Silicon Valley Bank.

Credit Suisse (CS) fell to a new record low. The lender has now agreed a $53 billion loan from the Swiss central bank, saying it is a “crucial measure to pre-emptively strengthen its liquidity”.

The move appears to have reassured investors for now as European bank stocks rallied on Thursday.

Although European banks are believed to be well capitalized, analysts say last week’s events could cause them to become more cautious about lending. That would weigh on economic growth and inflation and reduce the need for rate hikes.

The ECB’s decision, due at 9:15 a.m. ET, “is a test of the conundrum facing central banks,” said Adam Hoyes, an economist at Capital Economics.

“There is still a lot of uncertainty about what might happen next, but central banks… must now weigh the risk that the current situation will lead to a broader loss of confidence in the banking system and a significant tightening of financial conditions,” he added.

At 8.5% in February, inflation in the eurozone is still well above the ECB’s target of 2%. And Wednesday’s data showed a stronger-than-expected increase in industrial production in the 20 countries using the euro.

The ECB and other central banks will weigh inflationary pressures against the risk of further stress on markets.

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By holding back policy decisions for financial stability reasons, the ECB risks giving the impression that its “commitment to price stability has been compromised,” Hoyes said.

But “pushing ahead with the tightening cycle regardless risks exacerbating the sell-off and threatening stability,” he added. “It’s an unenviable choice.”

And words are just as important as actions. ECB President Christine Lagarde needs to reassure investors that no major bank in the euro area is in the same situation as Credit Suisse and that she has her back.

“Communication will be crucial,” said Carsten Brzeski, Global Head of Macro at ING. “I still think the ECB will deliver the pre-announced 50 basis point rate hike today… coupled with the announcement of that [it] is ready to provide banks with additional liquidity if needed.”