Dispute among central bankers: How high should interest rates rise?

ECB President Lagarde has announced a further tightening of monetary policy. But more and more monetary authorities want to end the interest rate cycle. They argue with concerns about the economy and falling inflation.

The Croatian municipality of Bregana is probably unknown to most tourists – or at most familiar through an involuntary stay. Because in summer there have been frequent traffic jams and excruciatingly long waiting times at this border crossing to Slovenia. For New Year’s Day, the small town dressed up, because none other than EU Commission President Ursula von der Leyen swooped in to celebrate something big with Croatia’s Prime Minister Andrej Plenkovic: the country’s accession to the Schengen area and the European Monetary Union.

Ambiguous attitude towards the euro

This not only opened the barriers, Croatia also became the 20th member country of the Euro Club at the turn of the year. After greeting at the border, the two politicians drove to the nearby capital Zagreb to have a coffee together. Paid with brand new Croatian euro coins.

The four million Croatians have mixed feelings about joining the euro zone. While for many the popular holiday destination on the Adriatic has finally arrived in Europe, others mourn the loss of the local currency kuna as a symbol of independence. In addition, many in Croatia have lost enthusiasm for the euro project. The promises of stable prices, low interest rates and great prosperity have long been obsolete. With inflation of 13.5 percent recently, Croatia is one of the countries with particularly high inflation.

Tip the scales?

Under normal circumstances, where the so-called Maastricht criteria still applied somewhat, such an inflation rate would have immediately thwarted Croatia’s accession. But in times when the currency watchdogs in Frankfurt also have to answer for inflation data that is five times as high as the desired target of two percent, access hurdles no longer play a major role. Many locals fear a further surge in inflation, because traders tended to round up rather than down when converting from kuna to euros.

In terms of monetary policy, Croatia is in the middle: central bank head Boris Vujcic is seen neither as a relaxed “dove” nor as a restrictive “hawk”, but is grouped in the neutral camp. Together with his Lithuanian and Luxembourg colleagues, who are also neutral, and the two board members Schnabel and Elderson, he could tip the scales in the future.

Clear signals from Lagarde

Because the skirmishes between the two camps are getting stronger again. Startled by record inflation, which peaked at 10.6 percent in October, many “doves” gave up their resistance and agreed to a tightening of monetary policy: the European Central Bank has raised interest rates four times since last summer. These included two jumbo steps of 0.75 percent points. The main interest rate is currently 2.5 percent.

Interest rates are likely to rise again this week. At the World Economic Forum, ECB President Christine Lagarde left no doubt that monetary authorities would continue to tighten interest rates. “Inflation is far too high,” she said in snowy Davos. “We will stay the course until we have stayed in the restrictive zone long enough to bring inflation back to 2 percent in time.”

“Disappointed by the ECB”

Lagarde knows it all too well: large parts of the population are extremely dissatisfied with the monetary authorities and their lax handling of inflation. Just recently, the ECB President had to get a resounding slap in the face from the otherwise rather diplomatically reserved and former ECB chief economist Ottmar Issing: “I’m disappointed in the ECB,” says the economist, who ensured stable prices for eight years during his tenure , in the “Frankfurter Allgemeine Sunday newspaper.” “And that’s because it reacted so late to the emerging dangers of inflation.”

In fact, the ECB waited for months and did nothing, while other central banks around the world reacted and raised interest rates, in some cases sharply. As a result, the euro also slipped, which made the situation even worse because imported goods became more expensive and fueled inflation further. The bottom line is that the long hesitation on the part of the currency watchdogs led to massive currency devaluation and significant losses in prosperity, which also widened the gap between rich and poor in Europe.

Even if you exclude the volatile prices for energy and food from the inflation rate, the resulting core inflation is more than twice as high as targeted – actually a clear sign that further strong interest rate hikes are essential. The sometimes very high wage agreements, which threaten to further fuel inflation, also speak in favor of further interest rate hikes.

Monetary “doves” in the majority

But in the background the “pigeons” are already grumbling. According to an analysis by Commerzbank, their camp is stronger than ever: 15 “doves” are opposed to only six “hawks”. One of its leading representatives is Italian ECB Executive Board member Fabio Panetta. He has long been warning of the negative consequences of rising interest rates for the economy.

“In the current situation, we must not commit ourselves to a specific interest rate development for too long,” he said in the “Handelsblatt”. In fact, it is probably more about limiting the rising refinancing costs for Italy and other southern countries. Because if interest rates rise, countries have to pay higher interest rates for government bonds.

An increase in key interest rates of 0.5 percentage points has been announced for this month, and a further step of the same amount is expected for March. From May at the latest, the strong camp of the “pigeons” should step on the brakes. At that point, a significant slowdown in inflation is expected, which proponents of loose monetary policy are likely to use as a justification for raising interest rates less sharply.

Prices are unlikely to go down again

For the population, however, the inflation problem should not be over. Even if inflation slows down, inflation rates of between five and six percent are expected – still around three times as high as desired. And a slowdown doesn’t mean prices will fall again; it just means they’re going up less.

The high inflation can also be felt on Croatia’s Adriatic coast. The good times in tourism are long gone. But even if the introduction of the euro in Croatia does not make it cheaper for vacationers: Traveling with the common currency is now definitely easier.