To: 21/07/2022 19:18
For the first time in more than a decade, the ECB raised interest rates again. What are the consequences? Why is this not enough for some experts? And why is Italy putting the central bank in a dilemma?
This is an important step: after more than a decade of accommodative monetary policy, the European Central Bank (ECB) has decided to start tightening its monetary policy and has thus started the recovery of interest rates. “We have decided to raise interest rates by 0.5 percentage points,” ECB President Christine Lagarde said in Frankfurt. At the same time, it announced further increases in key rates. The historic abandonment of loose monetary policy is also a farewell to penalties for commercial banks and zero interest rates for savers.
Stronger increase than announced
At the last ECB Council in Amsterdam, the monetary authorities announced an increase of only 0.25 percentage point. Some experts were therefore surprised. “Personally, I was surprised that the ECB raised the key rate by 50 basis points because it announced 25 basis points more precisely than ever before in June,” says Emanuel Mönch, professor of monetary policy and financial markets at the Frankfurt School of Finance. & Management, in conversation with tagesschau.de. This is a clear signal that the ECB is now trying to control the curve in the fight against high inflation.
“The Governing Council of the ECB has deemed it appropriate to take a first, larger step towards the normalization of key interest rates than it announced at its last meeting,” the central bank explained. It is based on the updated assessment of inflation risks by the Governing Council of the ECB.
For former economist Volker Wieland, it is “a glimmer of hope” that the central bank is now raising interest rates faster than expected. Because the increase “comes too late and is not sufficient to effectively fight against inflation,” said the professor of monetary economics at Goethe University in Frankfurt. tagesschau.de. Inflation expectations have risen much more sharply in recent months, so real interest rates are still lower.
Inflation at historic highs
“The ECB did not react to the rise in inflation. It was already foreseeable in the spring of 2021 that it would rise significantly. Even then, the ECB should have adjusted its very accommodative monetary policy,” Wieland said. Radio Hesse. Because it didn’t, it contributed to inflation and rising expectations. The war in Ukraine and the explosion in energy prices have only been a “fire accelerator”. “The ECB is reacting much too late and too cautiously.”
In view of the record inflation in the euro zone, other experts had also called for an even greater increase in key rates. In June, consumer prices in the eurozone were 8.6% higher than in the same month last year. For 2022 as a whole, the European Commission estimates an average inflation rate of 7.6% in the currency area of the 19 countries – an all-time high.
The inflation rate is therefore well above the annual target of 2% that the ECB is striving to achieve. Higher inflation reduces the purchasing power of consumers because they can afford less for a euro. The drivers of inflation for months have been significantly higher energy and food prices. The Russian war of aggression in Ukraine has further aggravated the situation.
Far behind other central banks
Critics have long accused the ECB of starting the interest rate hike much too late. “Compared to other central banks, the ECB is far behind in the rate hike cycle,” explains expert Mönch. It was now up to him to react quickly “in order to bring inflation under control to some extent”. For comparison: the US Federal Reserve, for example, has raised interest rates to the current range of 1.5-1.75% since the spring. The rate hike in June alone was 0.75%, making it the largest increase since 1974. In Canada, the monetary authorities even raised the key rate by one percentage point.
However, the ECB does not have it easy either: due to the current energy crisis, the rise in interest rates actually comes at the wrong time, says Christina Bannier, professor of finance at the University of Gießen, in an interview with the Radio Hesse“On the one hand, we have the inflation rate which increases enormously, on the other, the risk of a recession or a sudden weakening of the economy.” The former speak of more aggressive interest rate hikes, the latter of lower interest rates to support the economy.
Because high interest rates continue to stifle the weakness of the economy, according to economic theory, because investments for businesses become more expensive and private consumption weakens due to more expensive loans. It is therefore understandable for Bannier that the ECB, unlike other central banks in the world, proceeds much more cautiously.
The ECB faces a dilemma
Mönch, of the Frankfurt School of Finance & Management, also sees this dilemma: “It’s a very difficult situation for the central bank. Some of these price drivers have little to do with demand effects.” Instead, the economy is more likely to be burdened on the supply side: by supply chain bottlenecks following the pandemic or the war in Ukraine, which affects energy price. Traditionally, a central bank cannot do much about it.
To the weakness of the euro, which makes imports more expensive and further fuels inflation, is added the high level of indebtedness of the States of southern Europe, for which interest rates raised too quickly can become a burden. “Long-term low interest rates have not been used well enough by some European countries to reduce their debt ratios,” says Mönch. The financial markets are very skeptical about the ability of these countries to survive the turnaround in interest rates.
Because the decision to put an end to bond purchases and the announcement of the rise in interest rates in June had already pushed up yields. In order to support highly indebted States in the event of turbulence on the bond market, the monetary policemen have agreed on a new program for the purchase of crisis bonds. Work had already been accelerated in June.
New anti-crisis tool
The new “Transmission Protection Instrument” (TPI) tool should help to ensure that monetary policy can have an equal effect in the euro zone and that the financing costs of the different euro zone states do not diverge. The yield gap – the spread – between the government bonds of Germany and those of more indebted eurozone countries, in particular Italy, has widened recently. In other words, for countries like Italy, where the government crisis is making markets even more jittery, it will be more expensive to get fresh money.
However, uniform monetary policy across the Governing Council is a prerequisite for the ECB to fulfill its price stability mandate, the central bank said. TPI was created for specific situations and risks that may affect all countries in the euro zone. If necessary and based on certain indicators, the Board of Governors will decide whether the program will be activated for a country and what the scope will be. In addition, it is linked to several conditions, such as debt sustainability.
“I fear that the ECB cannot avoid using the program,” explains expert Wieland. Expectations are very high and, especially in Italy, investors would demand a high premium in the government crisis. He considers TPI to be “very problematic”. After all, it is normal that the most indebted countries have to pay higher interest premiums in the market when they tighten. Additionally, the central bank has largely undermined the market over the past two years with its Pandemic Emergency Purchase Program, so premiums over the past two years do not reflect a market premium.
The TPI will apparently not be used in the Italian case for the moment
The expert Mönch, on the other hand, understands the ECB a little: “The central bank must define monetary policy for all member states and ensure that the decision on interest rates reaches all countries. If there is turbulence in the financial markets, the effectiveness may be limited.” It is not clear whether the new instrument will really calm the situation. If the crisis in Italy worsens, the ECB may have to spend a lot money to artificially lower interest rates on Italian government bonds.
“The proportionality of the measure in relation to its primary objective of maintaining price stability, demanded by the Federal Constitutional Court, could then become a tightrope walk”, believes Mönch. In summary, it is economically and legally difficult. Whether the ECB is already using the TPI in the current situation around Italy remains open. Insiders say an operation is not imminent as conditions would not warrant it, according to several people familiar with the situation at the press briefing. Reuters reported.
Independent of the new purchase program, further interest rate steps are to follow in the future. “Further rate normalization will be appropriate in our upcoming rate meetings,” Lagarde said. By advancing the exit from negative interest rates, the monetary authorities could also switch to the fact that interest rate decisions would now be taken from meeting to meeting. “We will proceed month by month and step by step,” Lagarde said. The future path will depend on the data situation. Many economists assume that the interest rate will have risen to 1.5% by next spring.
With information from Ursula Mayer, Hessischer Rundfunk.