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Turnaround in interest rates in Europe: why the ECB is so hesitant

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Status: 07/21/2022 04:28

The ECB will raise interest rates today for the first time in about eleven years, albeit moderately. The timing of this step could hardly be worse.

By Klaus-Rainer Jackisch, Mr.

For two good years, the corona pandemic also held the ECB firmly in its grip: the highest level of security applied in the Eurotower in Frankfurt; The glass building on the Main has been deserted for months and most staff have been working from home. The traditional press conferences following monetary policy meetings were also held by video link. The pandemic is far from over. But this week, the chairman and vice-chairman in Frankfurt go to the press again in person. They will announce historic news in the history of the ECB: For the first time in more than a decade, the monetary authorities will raise interest rates, drawing a line under the era of accommodative monetary policy.

Planned gradual increase

The amount of this step was already set at the last ECB Council in Amsterdam: the key rates must increase by 0.25%. ECB President Christine Lagarde has made it clear that this is the “beginning of a journey” in which interest rates will be raised further in the coming months. Many economists assume that the interest rate will have risen to 1.5% by next spring.

The hesitant approach does not seem particularly effective given the current record inflation rate of 8.6% in the euro zone and the prospect that inflation for the year as a whole will also head towards an all-time high. by 7.6%. Many observers are therefore calling for a significantly higher interest rate hike of at least 0.5% at the start. These voices are also shared within the Governing Council of the ECB. However, it is questionable whether this will happen: on the one hand, because the monetary authorities in Amsterdam have already made a decision. On the other hand, because large parts of the Board of Governors do not feel comfortable with developments anyway.

“Actually at the Wrong Time”

Because the ECB could hardly have chosen a worse moment for the recovery of interest rates. Given the economic development, the step comes “in fact at the wrong time”, write the economists of the Bankhaus MMWarburg. Because triggered by the war against Ukraine, the aggravation of the energy crisis, in particular a possible stoppage of gas deliveries from Russia, could plunge the economy of the euro zone into a severe recession.

In such a situation, interest rate hikes are generally a poison: they continue to stifle the weakness of the economy because it makes investments more expensive for companies and private consumption tends to weaken. But with record inflation, more than four times higher than the 2% target and which has now exceeded 20% in some Member States such as Estonia, the monetary authorities have no choice but to lose their confidence. .

The ECB is lagging behind

It is now detrimental that the ECB has been too tentative and hesitant in recent months and has systematically underestimated inflation dynamics. Most of the world’s central banks have long reacted to the global phenomenon of high inflation and are trying to counter this by raising interest rates, some of them significantly. According to a survey by the International Monetary Fund (IMF), 75 central banks around the world have already raised their key rates since July 2021 – sometimes very aggressively. This is particularly the case of the American central bank, the Federal Reserve: since the spring, it has raised key interest rates there to the current range of 1.5 to 1.75%. The rate hike in June alone was 0.75% – the biggest increase since 1974.

Asked about the various developments in the United States and the eurozone, ECB President Lagarde repeatedly dismissed criticism of her company’s policies. She pointed out that the situation in North America and the Eurozone is completely different. Therefore, there must also be different monetary policy reactions, which justifies the ECB’s cautious course.

Situation in the United States and Europe not comparable

At first glance, this also seems to be true: the structure of inflation in the two regions is indeed of a different nature. In Europe, it is mainly fueled by war, which makes energy and raw materials massively more expensive. On the other hand, you can’t do much with higher interest rates. In the United States, inflation tends to be “house”. It was created by an overheating economy as a counter-reaction to the Corona-related crash.

It is true that the war against Ukraine is also driving up energy prices in the United States, as quotations are made on international markets. However, the country has the great advantage of being able to supply itself with oil and gas to a large extent and, unlike large parts of Europe, it is not dependent on Russian gas supplies. Under such conditions, rate hikes can be much more effective as they have a greater effect in fighting inflation.

Price-wage spiral and weak euro

At first glance, however, the ECB’s arguments are only half true, as the central bank is itself the engine of inflation in Europe with its restraint. On the one hand, because the population expects further price increases as a result; these should translate into higher wages, which means that companies can raise prices again and inflation can therefore take hold. On the other hand by the effect of the exchange rate mechanism. With interest rates in the United States now much higher than in the Eurozone, many large investors have shifted their investments to the United States, which is much more attractive. This massively strengthened the US dollar and, as a result, caused the euro to fall. Recently, it has even sometimes fallen to parity with the dollar, so that one euro was only worth around one dollar. In that year alone, the common currency lost about twelve percent of its value against the dollar.

However, since energy and commodities in global markets are usually settled in US currency, Europeans currently have to put far more euros on the table for them. Low interest rates in the euro zone therefore further increase the cost of energy imports, which are already expensive. Consumers have to foot the bill through rising prices.

Debt burden depresses southern European eurozone states

Finally, the ECB is once again a prisoner of this crisis in its role of firefighter for the euro zone. Because many council members fear that the end of accommodative monetary policy will make it more expensive to finance national budgets in southern European countries. In fact, government bond yields rose there immediately after the decision to end bond purchases and raise interest rates – especially in Italy, where the current government crisis is contributing to this development.

Faced with this situation, the ECB quickly convened an emergency meeting just days after the Council meeting in Amsterdam. Some spoke of the start of a new euro crisis, but in reality monetary union is far from it. Nevertheless, the ECB wants to present a new emergency instrument this week to cap the excessive rise in government bond yields.

It remains a balancing act for Lagarde

This has already drawn a lot of criticism: “Financial support for highly indebted countries is (…) not part of their mandate”, says ifo President Clemens Fuest of the ECB’s proposal. This focus on problems that in fact have to be solved by governments diverts attention from the real task of the ECB: ensuring price stability.

The monetary authorities are therefore faced with a dilemma: they must raise interest rates to fight against inflation, but the economic situation actually speaks against it. At the same time, they constantly set themselves pitfalls because they have to watch over the flawed construction of the monetary union, which is not their job. In this difficult situation, the ECB at least dares to make a fresh start and initiates a turnaround in interest rates. But it will probably be a tightrope walk for President Lagarde when she announces it at the press conference in Frankfurt.

The European Central Bank (ECB) |  photo alliance / Daniel Kubirs

The European Central Bank (ECB) |  photo alliance / Daniel Kubirs

The new crisis instrument reaches the legal limits

The ECB has announced a new crisis instrument with which it intends to prevent government bond yields from spiraling out of control. With this program, called TPM (Transmission Protection Mechanism), the central bank wants to buy government bonds from each eurozone country – unlimited if necessary.

It is still unclear what conditions these purchases are subject to. Such an instrument already exists: it is called OMT (Outright Monetary Transaction) and was created in the wake of the euro crisis. However, the purchase of government bonds here is subject to very strict conditions, which oblige the countries concerned to implement far-reaching reforms. Therefore, the program was never used.

According to some reports, these conditions should be much more relaxed in the program currently envisaged. There would then no longer be any constraint, for example, for an over-indebted country to put its finances in order. This reduces the barrier to take advantage of the TPM program; the central bank could therefore act more quickly. The instrument raises legal issues, as the ECB is actually prohibited from openly funding states.

Rising government bond yields were one of the main triggers of the euro crisis from 2010 to 2012. At that time, speculation was made against highly indebted eurozone countries, which pushed their yields higher and higher. This development, which essentially represented an existential threat to the European monetary union, was prevented by the famous appearance of the then ECB President, Mario Draghi, in London: “Whatever is necessary to preserve the euro will be done”, he said there (“Whatever the cost” speech). This was followed by several ECB bond buying programs which ended speculation and normalized the evolution of yields.

Source www.tagesschau.de

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