ECB policy – time for interest rates to rise

Key points at a glance

• Inflation is back. The pandemic and geopolitical tensions have caused major negative supply and demand shocks.
• There are different drivers for inflation, so a distinction must be made between demand-pull and cost-push inflation.
• Inflation has a direct impact on the real value of a currency, causes a decline in real disposable income, erodes purchasing power and causes the real value of savings to fall.
• Price stability is the primary goal of most central banks, which is why they are attempting to rein in inflation with aggressive tightening.
• The ECB is facing enormous challenges and its window of opportunity is closing.

After several consecutive months of record high inflation levels, the ECB finally acted – or rather reacted – in July, raising interest rates for the first time in more than ten years. How should we view this move, and what will be its impact and consequences?

But firstly, it is key to understand the crux of the matter. What does inflation really mean? Inflation refers to a general increase in the price of goods and services. It represents a rise in the cost of living which affects the living standards of households, and corporate production and investment decisions. Inflation has a direct impact on the real value of the currency, as households can purchase fewer of the items they typically consume with the same amount of money. So as inflation rises, the currency loses value.

The causes of inflation

There are two types of inflation. Demand-pull inflation is an increase in prices as a result of macroeconomic measures, which are generally a consequence of lax central bank monetary policy or expansive government policy. If central banks cut interest rates, or governments raise spending or cut taxes, this leads to an increase in aggregate demand. If the rise in aggregate demand exceeds the production capacity of the economy, the resulting pressure on resources is reflected in demand-pull inflation. In contrast, cost-push inflation is the result of supply-chain bottlenecks, interruptions caused by natural catastrophes or wars, and rising commodity prices, which disrupt production or increase production costs. Cost-push inflation impacts retail prices via the entire production chain. Monetary policy generally has little influence on containing cost-push inflation as tighter policies do not help restore supply.

The costs of inflation

“High inflation may result in social tension,
as it widens the gap between rich and poor.”

Dr Andrea Siviero

High and fluctuating levels of inflation are associated with considerable costs. At the macroeconomic level, higher prices and uncertainty surrounding future price levels may lead to a misallocation of resources, less investment, and lower economic growth. In general, high inflation also results in higher borrowing costs, which depresses investment and slows economic activity. From an international perspective, high domestic inflation undermines the competitive position of local companies, which in turn results in lower exports, reduced earnings and fewer jobs.

Inflation acts as a tax on consumption, investment and production for private households and companies. As Nobel Prize winner Milton Friedman once remarked, “Inflation is the one form of taxation that can be imposed without legislation.”

If the nominal income of private households fails to keep up with inflation, they can afford to buy less and bear the full brunt of the consequences of inflation. In other words, inflation causes a decline in real disposable income, erodes purchasing power and causes the real value of savings to fall. Real income is a proxy for living standards. If real income rises, so do living standards, and vice versa. High and persistent inflation will reduce living standards, restrict consumption and have a negative impact on GDP growth. Inflation is particularly harsh on low-income households and the elderly as food, housing and energy costs account for a large proportion of their outgoings. High inflation may therefore result in social tension, as it widens the gap between rich and poor.

The mandate of central banks

Price stability is the primary target of most central banks as laid out in their legal mandate. The independence of central banks and the gradual introduction of inflation targets have significantly improved the credibility of central banks on tackling inflation since the early 1990s. Most central banks in developed countries aim to hold inflation at a low and stable level, generally targeting an inflation rate of around 2%. Low and stable inflation creates an environment that favours economic growth, investment and competitiveness, while avoiding boom and bust cycles. After a decade of very low inflation, central banks have gradually made it clear that the inflation target of 2% should be considered symmetric, as excessively low inflation and deflation are also a risk to economic growth.

Inflation is back

Inflation remained particularly low in most developed economies after the global financial crisis. Despite extremely accommodative policy and low unemployment rates, inflation remained below central bank targets for a decade. Economists have come up with a number of potential reasons for the unusually low inflation level, including well-anchored inflation expectations, demographic transition, globalisation and technological progress.

This situation changed dramatically last year due to the rapid recovery of the global economy from the COVID-19 pandemic. The supply side could not keep pace with the rise in aggregate demand fuelled by unprecedented policy support from the fiscal and monetary authorities. The mismatch of a strong rise in demand and insufficient supply resulted in a major boost to prices. Central banks assumed that price rises would gradually subside and that, little by little, inflation would return to pre-pandemic levels once equilibrium had been restored in the global economy and difficulties related to the pandemic gradually resolved.
However, in the first quarter of this year, the global economy was struck by two major negative supply and demand shocks – the war in Ukraine and the renewed COVID-19 outbreak in China – which pushed the world to the brink of stagflation and made it clear that it would not be possible to ramp up supply quickly enough to cover demand and avoid inflation becoming entrenched across the board.

It is not clear whether recent developments represent a shift in longer-term inflation momentum, but central banks across the world have started to aggressively tighten policy to rapidly depress demand and curtail inflation and inflation expectations.

The ECB is in a tight spot

“The window of opportunity for the ECB is closing.
It is lagging behind other major central banks in the fight against inflation
and would be well-advised to further tighten its policy in the coming months,
to gain the policy leeway necessary to deal with the looming threat
of recession and any future exogenous shocks.”

Dr Andrea Siviero

The situation varies greatly from region to region due to asynchronous economic cycles and differing causes of inflation. The robust economic upturn in the U.S. pushed inflation in June up to a level not seen in decades – of 9.1% – and the unemployment rate down to the pre-pandemic level of 3.6%. The U.S. Federal Reserve introduced a cycle of aggressive tightening in March, against the backdrop of sound economic growth and a strong political commitment to quash inflation. The Fed has raised the federal funds rate by 2.25% overall and plans further hikes to curb aggregate demand, thus anchoring inflation expectations and bringing inflation back down to the 2% target.

The European economy has not recovered as quickly as the U.S. from the recession caused by the pandemic. The eurozone is highly dependent on Russian energy and was hit hard by the conflict in Ukraine. Consumer confidence is declining, manufacturing is suffering from supply-chain bottlenecks due to the COVID-19 outbreak in China, and the economy is slowing. The task of the ECB is extremely difficult due to a number of factors: a) European inflation has been caused primarily by high energy and commodity prices, and tighter monetary policy will have little impact on stamping out cost-push inflation; b) tightening policy while the economy is slowing increases the risk of recession; c) public finances are strained at the national level and there is little appetite for coordinated fiscal support at the eurozone level; and d) interest rate hikes in the eurozone do not enjoy widespread political support while economic differences across the region mean that aggressive tightening could result in undesirable market fragmentation in the Eurozone bond market.

As inflation has reached an all-time high of 8.9% and the ECB is in danger of losing control of inflation expectations, it initiated a cycle of tightening on 21 July with an interest rate hike of 50 basis points. The ECB’s decision was accompanied by the introduction of a Transmission Protection Instrument (TPI) aimed at preventing a widening of eurozone sovereign bond spreads. This is a step in the right direction, which gives the ECB some leeway for further rate hikes and could at the same time prevent the risk of market fragmentation. However, the situation remains particularly challenging for the ECB, which is juggling the risks of stagflation, recession and political tensions within the eurozone.

The way forward

The ECB must come to a decision on how to proceed and in this should be scrupulously guided by its mandate as laid down in Article 127 of the Treaty on the Functioning of the European Union (TFEU). This states: “The primary objective of the European System of Central Banks (ESCB) shall be to maintain price stability. Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Union (...)”.

This means that price stability is the primary objective of the ECB, while providing support for economic measures within the Union is secondary and is only appropriate providing it does not undermine the objective of price stability. In this respect, the ECB’s decision to act swiftly and decisively to bring inflation under control is fully justified by the record high level of inflation currently.

In the current situation the ECB could not hold off any longer in the hope that inflation would decline as economic growth subsided. Any further delay to the introduction of measures would unnecessarily prolong the current phase of damaging stagflation and postpone the cycle of tightening, damaging European citizens – particularly the most vulnerable – and exacerbating social tensions while not offering any tangible response to the inflationary environment.
A weak reaction to record high inflation would also irreparably damage the credibility of the ECB. Central banks know only too well that a loss of credibility can be extremely costly, as it can condemn them to longer and more painful tightening cycles. The ECB must send a clear signal that it will not accept inflation becoming entrenched. It will therefore continue to act decisively to anchor inflation expectations.

The ECB does not have a firm currency target, but the sharp depreciation of the euro recently is damaging the inflation outlook and European consumers. The divergence of regional monetary policy measures is one of the main reasons for euro weakness. Decisive ECB action could provide a boost to the euro and protect the eurozone from a further acceleration of inflation.

The window of opportunity is closing for the ECB. It is lagging behind other major central banks in the fight against inflation and would be well-advised to further tighten its policy in the coming months, to gain the policy leeway required to deal with the looming threat of recession and any future exogenous shocks.

In the current situation, the ECB is facing the enormous challenge of tightening policy as the economy weakens and economic differences and political instability resurface in the eurozone. The eurozone was created with the original sin of a single currency for countries with diverging economic performance which are driven by national interest. However, the ECB cannot be held accountable for the structural weaknesses of the European framework and should focus on its mandate of price stability, taking the right decisions for the well-being of European citizens.