ECB before interest rate hike: Monetary authorities in a dilemma

The record inflation in the euro area puts the monetary authorities under pressure to act. The ECB is likely to react by raising interest rates sharply. In doing so, she risks further choking off the ailing economy.

The employees in the discounter branch could hardly believe their eyes: the mixed vegetables from the freezer, which were available at a special price, were sold out within a few minutes. The competition had cheaper pizza and butter – and they were gone in no time. And last week, petrol cans were no longer available at many hardware stores. Because before the tank discount expired, many stocked up on liters of fuel to avoid the expected price hike.

Credibility is at stake

The Germans are afraid. You’re afraid of inflation. And they do everything to somehow avoid the constantly rising prices – even if it sometimes bears grotesque features. The massive increase in prices is currently the biggest concern that worries people in this country. It has thus pushed Corona out of first place. This is the result of a study by the market research institute GfK: 84 percent of those surveyed are concerned about rising energy prices and 80 percent about food prices. The result: More and more people are losing confidence that the currency watchdogs can get the runaway inflation under control.

These developments have now set the alarm bells ringing at the European Central Bank (ECB). She now fears for her reputation and her credibility. This is the only way to explain the new tone that the currency watchdogs are striking. Ironically, ECB director Isabel Schnabel, who for months had repeatedly calmed down and declared that inflation was only a temporary phenomenon, now found clear words.

At a US Federal Reserve symposium in Jackson Hole, she said the central banks must now act effectively. “The longer inflation remains high, the greater the risk that the public will lose confidence in our determination and ability to maintain purchasing power.” If monetary policy does not change quickly enough, the consequential costs may be considerable. It is therefore necessary to bring inflation back to the target value of two percent.

More than 20 percent inflation in some euro countries

However, the monetary watchdogs are miles away from that at the moment: in the euro zone, inflation reached a new record high of 9.1 percent in August. In many countries it has gotten completely out of hand – for example in the Baltic States, where it has been over 20 percent for months. Estonia currently has the highest value at 25.2 percent. According to European calculations, the inflation rate in Germany is 8.8 percent, according to German statistics 7.9 percent – all highs since the introduction of the euro.

On the financial markets, Schnabel’s statements were understood to mean that the ECB is now stepping up the pace to take action against inflation. Numerous ECB council members are also calling for this – above all Bundesbank President Joachim Nagel. For more and more people, inflation is becoming an enormous burden. It is therefore “urgently necessary for the Governing Council to act decisively at its next meeting to combat inflation,” said the central banker. There is support mainly from the Netherlands and the Baltic States.

After the monetary watchdogs initiated the turnaround in interest rates in July, observers expect that the interest rate step announced will now turn out to be larger than expected. They expect an increase of 0.75 percentage points instead of the announced 0.5 percentage points. This would increase the main interest rate to 1.25 percent. But even then, European interest rates would only be half as high as in the US, where inflation is at similar record levels. Many economists are therefore calling for further strong interest rate hikes. For example, Commerzbank chief economist Jörg Krämer currently considers an interest rate level of at least four percent necessary if one really wants to get the rapidly rising inflation under control.

Which means high interest rates

There are several reasons for an overall hesitant and not very powerful monetary policy: for example, the concern that interest rates that are too high could again put the clammy southern European countries in trouble. Because they have to pay more interest due to the higher interest rate level if they take on new debt. However, there are also serious fears that excessive interest rate hikes could further stifle the economy. It is already suffering from broken supply chains, skyrocketing raw material and energy costs and a collapse in consumer confidence. If interest rates continue to rise significantly, this could weigh on the economy even more.

Rising interest rates lead – at least in theory – to consumers saving more money and thus consuming and spending less. As a result, companies are left with their goods and produce less. Also, higher interest rates mean that companies have to pay more for credit, causing innovation or investment to be postponed. The result of both developments: the economy is shrinking, the economy slides into recession, unemployment is rising.

How much more can the central bank do?

The ECB must therefore choose between two evils: If it does not act decisively enough against the high prices, it will lose the public’s trust. But that is existential: Because like any currency, the euro only works if people have trust in the construct and can assume that the central bank will ensure that the purchasing power of the money is preserved. If the ECB acts too strongly, it will weaken the economy. That could also have massive consequences for the population, because a shrinking economy usually also leads to a shrinking labor market.

In addition, the ECB cannot work miracles anyway. It has no control over many of the factors that drive inflation. This includes the war against Ukraine, which makes energy more expensive, the supply chains disrupted by Corona, which make transport and raw materials more expensive, but also decarbonization, which can only be achieved at enormous costs and thus also drives inflation.

In essence, this means that inflation is here to stay. Low inflation rates of two percent or less are a thing of the past for the time being. But with the instruments it has, the ECB can at least dampen the overall level of inflation – this is what consumers and ultimately companies expect. There are many indications that the monetary watchdogs have recognized the signs.