On Thursday, the European Central Bank raised the key interest rate by 0.75 percentage points to two percent for the second time in a row. 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 has been in the history of monetary union.
The central bankers want to prevent record inflation from getting stuck 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.
However, traditional monetary policy only takes effect with a time lag. Experience has shown that it takes nine to twelve months before higher interest rates dampen consumption and investment in all economic sectors. The ECB expects inflation in the euro zone to be just under six percent next year. That’s three times what the central bank is aiming for.
serious consequences
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.
Experts assume that the euro zone will slip into recession next year. Some fear that if the ECB burdens households, companies and homeowners with higher borrowing costs through its interest rate policy, the downturn could worsen. 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.
The ECB Governing Council also has different views on how much interest rates should rise. Bundesbank President Joachim Nagel fears that the tightening of monetary policy will be stopped 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,” said Nagel last week in a speech.
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.
Monetary authorities have also decided to cap de facto subsidies for Europe’s big banks. In response to the Covid crisis, the sector received €2.2 trillion in cheap loans. The ECB experts overlooked the fact that the banking industry can benefit enormously from the turnaround in interest rates. Banks now park the loan funds at the ECB at higher interest rates than they have to pay themselves. Yields of tens of billions of euros beckon – without taking any risks. The central bank has now decided to adjust the interest rate downwards accordingly.