The European Central Bank has raised the key interest rate by 0.75 percentage points to two percent for the second time in a row. This is the highest level since 2009. “We will continue to raise interest rates in the next few meetings. I can’t say up to what level,” said ECB President Christine Lagarde after the monetary authorities’ decision on Thursday. “That’s not it with the normalization of monetary policy,” Lagarde continued. With this decision, the monetary watchdogs are underscoring their determination in the fight against sharp price increases. At 9.9 percent, inflation in the euro area in September was the highest it had been in the history of monetary union.
The end of loose monetary policy is controversial. Many experts expect that the euro zone will slip into recession next year, meaning that economic output will fall permanently. Some fear that if the ECB burdens households and companies with higher borrowing costs through its interest rate policy, the downturn could intensify. Italy’s new Prime Minister Giorgia Meloni and French President Emmanuel Macron recently warned against excessively large interest rate hikes in view of the weakening economy. “We have to do everything we can to fulfill our mandate – and that means ensuring stable prices,” Lagarde said of this criticism. “We are not blind to the threat of a recession. But high inflation is a particular burden for low-income households. So today’s decision is appropriate.”
The social consequences of rising prices are serious. In view of the massive increase in the cost of living, households with low incomes have to save even more, although this is hardly possible. Inflation also acts like a wealth tax on small and large savings deposits, which lose real value every day. The now higher interest rates on savings accounts are nowhere near enough to compensate for inflation. On the other hand, many rich people have invested their wealth in lucrative stocks and real estate.
Monetary policy takes effect with a delay
But there are also differences in the Governing Council as to how much the key interest rates should rise. Bundesbank President Joachim Nagel warns against stopping the tightening of monetary policy too soon. “Ending it too early could result in the phase of high inflation rates being prolonged, with the consequence that an even more restrictive monetary policy will later be necessary, which in turn could lead to an all the more severe recession,” says Nagel. Is there a dispute in the highest central bank committee? “The really controversial debates are not likely to be before the committee until next year,” says Friedrich Heinemann, economist at the Mannheim ZEW. “The high inflation and even more the increased inflation expectations speak for interest rate hikes towards values in the direction of four percent in the course of 2023.”
Traditional monetary policy only takes effect with a delay. Experience has shown that it takes nine to twelve months before higher interest rates dampen consumption and investment in all economic sectors. “We know that the rate hike has no immediate effect on inflation,” Lagarde said. Rather, the central bankers want to prevent record inflation from taking hold in people’s minds. The more consumers doubt that inflation will return to normal levels in the medium term, the more entrenched price increases could become. As a result, companies demand higher prices for their products based on their inflation expectations – and employees higher wages. There is a risk of an inflationary spiral. With its rigorous interest rate hike, the ECB wants to convince citizens that the price surge can soon be dampened. This is a difficult task, because the ECB itself expects inflation of almost six percent for 2023. That’s three times what the central bank is aiming for.
The rate hike could meanwhile stabilize the euro exchange rate. Europe’s common currency has lost around ten percent of its value on the foreign exchange markets since the beginning of the year. The euro is now trading at par to the dollar. The weakness of the euro is increasing the inflationary pressure in Europe. Because the raw materials, which are expensive anyway, such as oil, are billed in dollars, import costs are rising accordingly.
The monetary watchdogs have also decided to cap the de facto subsidies for Europe’s big banks. In response to the Covid crisis, the sector received €2.2 trillion in cheap loans in 2020. At that time, the ECB experts overlooked the fact that the banking industry could benefit enormously from the turnaround in interest rates that has now taken place: banks are now parking their loans with the ECB at higher interest rates than they have to pay themselves. That means returns of tens of billions of euros without taking any risk. The central bank now wants to cash in on this advantage. The conditions will be changed accordingly from mid-November.