As the traditional mathematical models for forecasting inflation became less and less able to anticipate the real price explosion, Christine Lagarde, President of the European Central Bank (ECB), showed her intellectual agility and stated: “We don’t just follow science. Our work also has something to do with art to do.” This means that the French and their central bank colleagues no longer want to just follow economic data when it comes to monetary policy, but also a kind of well-founded inspiration, which popular parlance would describe as a gut feeling.
The situation is unfortunate: on the one hand, prices are rising like never before in the history of monetary union. In September, the annual inflation rate in the euro area was 9.9 percent. On the other hand, inflation is not an expression of an overheated economy, as is otherwise known from textbooks. The high prices are a combination of exceptional events resulting from the corona pandemic and the Russian invasion of Ukraine. Don’t sharp rate hikes only make the situation worse?
Politicians are getting involved: Italy’s new Prime Minister Giorgia Meloni criticized in her first parliamentary speech that the interest rate hike in July – the first by the central bank in eleven years – was “a decision that many viewed as dangerous and that risks damaging bank loans to families and companies hold true”. French President Emmanuel Macron also recently warned that the central bank must be very careful with interest rate hikes. The price increase in Europe was mainly caused by external factors and had nothing to do with overspending by consumers.
Despite the criticism from the EU governments, the ECB will probably continue on its course
Nevertheless, the Governing Council of the ECB will probably continue on its course at its meeting on Thursday and make borrowing more expensive. Jörg Krämer, chief economist at Commerzbank, predicts: “We expect the central bank to raise the deposit rate by 0.75 percentage points to 1.5 percent. The central bank will increase the rate to 2.25 percent by the beginning of 2023.” Kramer even thinks it would be better to raise the key interest rate to four percent. This is the only way to “capture people’s expectations of inflation”.
Inflation expectations – the magic word. It’s about the danger that people will believe that prices will continue to rise sharply in the future. Dirk Schumacher, chief economist at the French investment bank Natixis, says: “The ECB is concerned with inflation expectations. Nobody believes that interest rate hikes will quickly lower inflation anyway.” In order to dispel these doubts, the ECB must act and raise interest rates further.
ECB President Christine Lagarde is also under pressure from consumers.
(Photo: Political Moments/Imago)
In fact, an August ECB survey shows that Europe’s consumers still expect inflation to be 3 percent even three years from now. This means that the ECB would still miss its target of two percent. “The issue is the credibility of the monetary authorities. They want to show that they take their mandate seriously,” says Schumacher. “If people trust the central bank, i.e. if they expect inflation to fall again, then they don’t have to raise interest rates so much. If mistrust increases, the monetary watchdogs have to raise interest rates more and accept a recession,” says the economist. There’s a lot of psychology involved.
And what about Meloni and Macron’s fears that excessively high interest rates – wherever they start – could worsen the recession? “The quicker the central bank takes tough action, the less damage the higher interest rates will do to the economy,” says Commerzbank chief economist Krämer. The main burden for the economy is anyway not the interest rate hike, but the energy shortage. Companies would shut down production because it no longer paid off. “At the same time, the unemployment rate in the euro area is lower than it has ever been in history, and there is a labor shortage that was not even seen during the economic boom,” says Krämer.
Europe’s banks are practically given money by the central bank
The Governing Council will also deal with Europe’s banks on Thursday. In response to the Covid crisis, the central bank had granted the sector subsidized loans totaling 2.2 trillion euros. This loan program, called TLTRO 3, has a side effect: the institutes get money as a gift. If a bank borrows one million euros from the ECB, it only has to repay 990,000 euros at the end of the term. You can keep one percent of the loan amount.
Now that interest rates are rising, the business for the banks will be even more lucrative. Europe’s financial institutions can park excess liquidity from the TLTRO loan program at the ECB and collect 0.75 percent interest – without having to take the entrepreneurial risk of lending. This should now be over: “The ECB will limit the risk-free profits for the banks from the TLTRO transactions. This is necessary because the industry as a whole is quickly at a profit of 100 billion euros,” says economist Schumacher. To do this, the rules would have to be changed: “But which bank will want to sue the ECB?”