ECB meeting: How experts assess the rate hike

The ECB is fighting the record inflation in the euro area with another sharp interest rate hike. Economists assess whether the XXL interest rate step was appropriate, actually dampens the high prices and how things could continue.

In order to get the record inflation in the euro zone under control, the European Central Bank (ECB) raised the key interest rate again by 75 basis points to 2.0 percent. Commercial banks can borrow fresh capital from the central bank at this rate. The deposit rate, which is decisive on the financial markets and at which the institutes park their money with the ECB, also increased by the same amount to 1.50 percent.

Despite the third tightening step in a row, the monetary watchdogs will remain on course to raise interest rates. The work is not yet done and there is still a long way to go, said ECB boss Christine Lagarde at the press conference today. There is more “in the pipeline”. It may be necessary to turn the interest rate screw at several council meetings. But how do economists rate the second XXL rate hike in a row?

Rate step “appropriate” and “right”

“I think the ECB hardly had an alternative due to the current level of inflation,” says Christina Bannier, Professor of Banking & Finance at the Justus Liebig University in Giessen tagesschau.de. Inflation in the euro zone climbed to 9.9 percent in September, driven by rising energy and food prices as a result of the Ukraine war. Inflation has never been this high since the founding of monetary union.

“An interest rate hike of 0.75 percentage points seems appropriate to me at the moment,” says Jan Pieter Krahnen, director of the Leibnitz Institute for Financial Market Research (SAFE) in Frankfurt. Emanuel Mönch, Professor of Monetary Policy and Financial Markets at the Frankfurt School of Finance & Management, takes a similar view: “Inflation is still high and there are signs of second-round effects.” It can already be seen that unions and employers are agreeing on significantly higher wage settlements and that rents are rising, which is contributing to a further rise in prices. “In this situation, a central bank cannot help but take countermeasures as quickly as possible.”

For the former economist Volker Wieland it was also the “right decision”, so in his opinion the increase could have been even higher by one percentage point. “The deposit interest rate relevant for the money market is now 1.5 percent. Of course, that’s not enough, further interest rate steps will have to follow,” says the professor of monetary economics at the Goethe University in Frankfurt in an interview tagesschau.de. The markets would expect three percent at the beginning of the new year. It remains to be seen whether the level will then be sufficient to push inflation back down to two percent.

Is monetary policy powerless?

According to the pure theory, interest rate increases make saving more attractive and borrowing more expensive, which leads to less consumption and investment. This causes prices to drop. According to a study by the German Economic Institute (IW Köln), monetary policy is currently “powerless against a large part of the current inflation”.

Accordingly, more than half (51.9 percent) of the basket of goods used to calculate the rate of inflation is determined by goods that are more influenced by the supply side. According to the IW, their price increases are due to increased energy and raw material costs and interrupted supply chains. Monetary policy, on the other hand, primarily affects the demand for goods and services.

“I think it’s wrong to claim that the ECB is powerless,” countered Wieland. In fact, it has a significant impact on inflation. Ultimately, inflation is a monetary problem, and it doesn’t matter what shocks it causes. “Whether there is inflation in the long term is a question of monetary policy,” said the expert. Because it is nothing other than the loss of purchasing power of the currency, the supply of which the ECB now controls. “With interest rates, the central bank has a strong lever, which allows it to influence inflation expectations.”

ECB wants to steer inflation expectations

These also play a role in the rate of inflation. There is a risk that market participants will perceive the high prices as the new normal. The monetary authorities are keen to avoid inflation getting stuck in people’s minds. The calculus: If inflation expectations get out of hand, it will be even more difficult for the ECB to contain inflation again and move it towards its target level.

In addition, inflation is never only determined on the supply side, adds Mönch from the Frankfurt School of Finance & Management. “Prices shoot up especially when there is low supply and high demand.” Reducing demand through higher interest rates therefore also has a dampening effect on inflation in the medium term.

In addition to the possible lack of effectiveness, some observers also fear a deterioration in the economy as a result of the tight monetary policy. Because higher interest rates make loans more expensive for households, companies and the state and make savings more attractive – which usually reduces consumption. Consumer sentiment in Germany, for example, has already been at a historic low for several months.

Recession no reason for experts to stop interest rate hikes

“Rising inflation is now going hand in hand with a sudden deterioration in economic growth prospects,” even the head of Italy’s central bank, Ignazio Visco, recently warned. “Against this background, rate hikes that are too rapid and significant increase the risk of a recession.” In the press conference, Lagarde also referred to the significant slowdown in economic activity in the third quarter. “And we expect further moderation later this year and early next year,” she said.

“A slight recession can hardly be avoided at this point in time; it may have already begun,” says Mönch. However, the labor market remains robust and the devaluation of the euro is helping the export economy. “If the situation in Ukraine and on the energy markets doesn’t deteriorate any further, I don’t expect a deep recession,” predicts the expert. “A recession is almost a side effect of the cure against rising prices,” emphasizes finance professor Bannier. Irrespective of this, the hike in interest rates is unavoidable: “The mechanism by which high interest rates affect the economy is the central bank’s central tool.”

Wieland also points to another aspect: “This time we are not experiencing a slump in demand while supply remains high. Instead, we have a slump in supply because production is falling due to the high energy costs.” In other words, inflation can tend to remain high or increase even during a recession because demand does not fall as quickly as supply. One cannot rely on the fact that the economic downturn alone will lead to a drop in prices.

What’s next?

Safe director Krahnen, on the other hand, sees a completely different risk: “I see the danger that the central banks do not take sufficient account of the fact that significant interest rate increases are being carried out in England and the USA at the same time.” The overall effect of simultaneous rate hikes could be stronger than expected. “That’s why I suspect that future interest rate increases will be significantly smaller than 0.75 – just to include the parallel effect in other closely related currency areas,” said Krahnen.

Today, they left open the pace at which monetary authorities will continue to raise interest rates. But it seems certain that they will continue. The Governing Council “assumes that it will continue to raise interest rates,” the central bank said. Bannier is also convinced: “I am firmly assuming that we will see further rate hikes.” The amount depends heavily on the further development of the current price-driving factors – i.e. primarily energy costs.

“Significant interest rate hikes are still necessary – possibly even exceeding the expectations of the financial markets of three percent in 2023,” says Wieland. He is not so sure whether the ECB will deliver that. According to the economist, there will be voices who believe that prices will automatically fall as a result of the recession or falling energy prices. “I think both are unlikely – inflation has long since spread.”