Status: 07/21/2022 04:28 am
The ECB will raise interest rates today for the first time in around eleven years – albeit only moderately. The timing for this step could hardly be worse.
For a good two years, the corona pandemic also had the ECB firmly in its grip: the highest security level applied in Frankfurt’s Eurotower; The glass building on the Main was deserted for months, and most of the employees worked from home. The traditional press conferences following the monetary policy meetings were also held via video link. The pandemic is far from over. But this week, the President and Vice-President in Frankfurt are again going to the press in person. They will announce historic news in the history of the ECB: For the first time in over a decade, the monetary authorities will raise interest rates, drawing a line under the era of loose monetary policy.
Gradual increase planned
The amount of this step was already determined at the last ECB Council meeting in Amsterdam: the key interest rates are to rise by 0.25 percent. ECB President Christine Lagarde made it clear that this is the “beginning of a journey” in which interest rates will be raised further in the coming months. Many economists are assuming that the interest rate will have risen to as much as 1.5 percent next spring.
The hesitant approach does not sound particularly effective in view of the current record inflation rate of 8.6 percent in the euro area and the prospect that inflation for the year as a whole will also be heading towards a historic high of 7.6 percent. Many observers are therefore calling for a significantly larger interest rate hike of at least 0.5 percent at the beginning. These voices are also shared in the Governing Council of the ECB. However, it is questionable whether this will happen: on the one hand, because the currency watchdogs in Amsterdam have already made a decision. On the other hand, because large parts of the Governing Council do not feel comfortable with the development anyway.
“Actually at the wrong time”
Because the ECB could hardly have chosen a worse time for the interest rate turnaround. In view of the economic development, the step comes “actually at the wrong time,” write the economists at Bankhaus MMWarburg. Because triggered by the war against Ukraine, the worsening energy crisis, in particular a possible stop in gas supplies from Russia, could throw the economy of the euro zone into a severe recession.
In such a situation, interest rate hikes are usually poison: they continue to choke off the weak economy because it makes investments more expensive for companies and private consumption tends to weaken. But with record inflation, which is more than four times above the 2% target and has now passed the 20% mark in some member states such as Estonia, monetary authorities have no choice but to lose their trust.
The ECB is lagging behind
It is now taking its toll that the ECB was too hesitant and hesitant in the past few months and systematically underestimated the dynamics of inflation. Most of the world’s central banks have long since reacted to the global phenomenon of high inflation and are attempting to counteract this by raising interest rates, some of them significantly. According to a survey by the International Monetary Fund (IMF), 75 central banks around the world have already increased their key interest rates since July 2021 – in some cases very aggressively. This applies in particular to the US central bank, the Federal Reserve: Since the spring, it has raised the key interest rates there to the current range of 1.5 to 1.75 percent. The rate hike in June alone was 0.75 percent – the highest jump since 1974.
When asked about the different developments in the USA and the euro zone, ECB President Lagarde repeatedly rejected criticism of her company’s policies. She emphasized that the situation in North America and in the euro area is completely different. Therefore, there must also be different monetary policy reactions, which justifies the cautious course of the ECB.
Situation in USA and Europe not comparable
At first glance, this also seems to be true: the structure of inflation in the two regions is indeed of a different nature. In Europe, it is fueled primarily by the war, which makes energy and raw materials massively more expensive. On the other hand, you can do little with higher interest rates. In the US, inflation tends to be “homemade”. It was created by an overheating economy as a counter-reaction to the Corona-related crash.
It is true that the war against Ukraine is also driving up energy prices in the USA, because quotations are made on the international markets. However, the country has the great advantage of being able to supply itself with oil and gas to a large extent and, unlike large parts of Europe, it is not dependent on Russian gas supplies. In such conditions, rate hikes can be far more effective because they have a greater effect in fighting inflation.
Wage-price spiral and weak euro
At second glance, however, the arguments of the ECB are only half true, because the central bank is itself driving inflation in Europe with its restraint. On the one hand, because the population expects further price increases as a result; these are likely to result in higher wages, which means that companies can raise prices again and inflation can thus become entrenched. On the other hand through the effect of the exchange rate mechanism. With interest rates in the US now being much higher than in the Eurozone, many large investors have shifted their investments to the US, which is much more attractive. This massively strengthened the US dollar and accordingly sent the euro plummeting. Recently, it even fell to par with the dollar at times, so one euro was only worth around one dollar. In this year alone, the common currency lost around twelve percent of its value against the dollar.
However, because energy and raw materials on the world markets are usually settled in US currency, Europeans currently have to put significantly more euros on the table for them. The low interest rates in the euro zone are thus further increasing the cost of energy imports, which are already expensive. Consumers have to foot the bill through the increased prices.
Debt burden depresses southern Europe’s euro states
Last but not least, the ECB is once again a prisoner in this crisis in its role as the fire brigade for the eurozone. Because many council members are concerned that the end of loose monetary policy will make financing national budgets in southern European countries more expensive. In fact, government bond yields there rose immediately after the decision to end bond purchases and turn interest rates – particularly in Italy, where the current government crisis is contributing to this development.
In view of this situation, the ECB promptly called an emergency meeting just a few days after its Council meeting in Amsterdam. Some spoke of the beginning of a new euro crisis, but in reality the monetary union is a long way from it. Nevertheless, the ECB wants to present a new emergency instrument this week to cap excessively rising yields on government bonds.
It remains a balancing act for Lagarde
This has already drawn many critics into action: “The financial support of individual highly indebted countries is (…) not part of their mandate,” says ifo President Clemens Fuest about the ECB’s proposal. This consideration for problems that actually have to be solved by governments distracts from the actual task of the ECB: to ensure price stability.
So the monetary watchdogs are in a dilemma: they have to raise interest rates to combat inflation, but the economic situation actually speaks against it. At the same time, they constantly set themselves pitfalls because they have to watch out for the shaky construction of monetary union, which is essentially not their job. In this difficult situation, the ECB is at least daring to make a fresh start and is initiating a turnaround in interest rates. But it is likely to be a tightrope act for President Lagarde when she announces this at the press conference in Frankfurt.
New crisis instrument reaches legal limits
The ECB has announced a new crisis instrument with which it intends to prevent government bond yields from getting out of control. With this program, called TPM (Transmission Protection Mechanism), the central bank wants to buy government bonds from individual euro countries – unlimited if necessary.
It is still unclear what conditions these purchases are subject to. Such an instrument already exists: it is called OMT (Outright Monetary Transaction) and was created in the wake of the euro crisis. However, the purchase of government bonds here is subject to very strict conditions, which force the countries concerned to implement far-reaching reforms. Therefore, the program was never used.
According to reports, these conditions should be much more relaxed in the program now being considered. There would then no longer be any compulsion, for example, for an over-indebted country to put its finances in order. This lowers the hurdle to take advantage of the TPM program; the central bank could therefore act faster. The instrument raises legal questions, because the ECB is actually prohibited from openly financing states.
The increase in government bond yields was a key trigger for the euro crisis from 2010 to 2012. At that time, speculation was being made against highly indebted euro countries, which caused their yields to rise ever higher. This development, which essentially represented an existential threat to the European monetary union, was prevented by the famous appearance of the then ECB President Mario Draghi in London: “Everything that is necessary to preserve the euro will be done,” he said there (” Whatever it takes” speech). This was followed by several ECB bond purchase programs that ended speculation and normalized yield development.