In its fight against high inflation, the European Central Bank has raised the key interest rate to 3.75 percent for the seventh time in a row. However, the surcharge of 0.25 percentage points was significantly lower than in the previous resolutions. “Inflation is too high, we know that we still have to do more. We’re not taking a break,” said ECB President Christine Lagarde on Thursday in Frankfurt. It is unclear how much interest rates would have to rise in order to bring inflation down from the current seven percent to the target of two percent. “I don’t have a magic number. It’s a journey, we’ll know when we’re there, when the rate hikes have the desired effect,” Lagarde said. Some central bankers on the Governing Council wanted to raise interest rates even more.
“In the euro zone there are now one or two more interest rate hikes, then there will be a break for the time being,” says Ulrich Kater, chief economist at Deka-Bank. It will only be seen towards the end of the year whether interest rates will continue to rise. “Then it is easier to assess whether the interest rate drug will work against the high inflation,” said the economist. The ECB wants to curb investment and demand with the higher interest rates, thereby reducing inflation. However, it usually takes more than a year for interest rate hikes to take full effect in economic life.
Europe’s central bankers are now paying more attention to the so-called core inflation, which excludes the particularly volatile prices for energy and food. This value, which better reflects the medium-term trend in price increases, was 5.6 percent in April, just a tenth of a percentage point below its highest level in the history of monetary union.
“Recent wage agreements have increased inflation risks,” said Lagarde. According to her, the stronger wage settlements should contribute more to inflation this year. The fear is that excessively high wage increases could trigger a dangerous wage-price spiral. In this case, companies reflect the higher labor costs on prices, which in turn leads to higher wage demands, i.e. inflation would feed itself.
At the same time, however, economists have found that it is also companies that are driving up inflation: They have increased their prices far more than the rising costs would justify and are making hefty profits. One now speaks of “profit-price inflation”.
The monetary authorities have raised the key interest rate from zero to 3.75 percent since July 2022. The high pace was necessary because the ECB had underestimated the risk of inflation for too long. The rapid increase in interest rates has consequences for the banking sector: key interest rates form the basis for price formation on the financial markets. Banks’ bond holdings lose more value with every interest rate hike. This results in losses for banks – initially “only” in accounting terms, because banks can hold the promissory notes until the end of the term, which means that the balance sheet minus gradually disappears.
The higher interest rates could lead to credit defaults in the US and Europe
But sometimes banks have to sell the bonds immediately, for example when savers reclaim their deposits. This happened to the American Silicon Valley Bank. In such a case, the losses hit the mark and, in the worst case, the bank’s equity is depleted. Most recently, the First Republic Bank had to be rescued – it was taken over by the major bank JP Morgan. Irrespective of this, the American Federal Reserve also raised the key interest rate further on Wednesday in view of the high inflation.
Experts assume that the higher interest rates will lead to credit defaults in the US and Europe because some private households, home builders and companies can no longer service their loans. This will put a financial strain on the banks. With the ongoing turmoil in the US banking market and the risk of the turmoil spilling over into Europe again, the question is: how long can the ECB continue its interest rate policy without stressing the economy and the banking system too much? The surprising bankruptcies of Credit Suisse and some US institutions shocked the financial sector so much that the banks subsequently made their lending to the economy more expensive and tighter. It is precisely this effect that the central banks want to achieve: That is why the ECB could perhaps end its rate hikes earlier than expected.