If the central banks take countermeasures too drastically in view of the high inflation rate, the economy will collapse. If they continue to watch, the inflation rate threatens to spiral out of control.
You can feel it in the supermarket, at the gas station, in the heating bills: inflation is picking up, recently fueled by the Russian war of aggression in Ukraine.
Central banks have long held onto the belief that the rise in prices as a result of the pandemic, high energy prices and faltering supply chains is only “temporary”. But it is now clear: you must act. The International Monetary Fund (IMF) is calling on central banks to “resolutely” adjust their course. Bundesbank boss Joachim Nagel says: “Monetary policy is required.” But when is the right time for a turnaround in interest rates?
interest rate instrument
Keeping inflation in check is the traditional task of central banks. The Federal Reserve (Fed) in the USA, the European Central Bank and others primarily use the key interest rate instrument for this purpose. The simplified idea: If you lower interest rates, more individuals and companies can afford a loan, which leads to higher spending, a growing economy and rising inflation. Theoretically, it works the other way around when interest rates rise: citizens and the economy borrow less money or have to spend more on loans, growth slows down, companies can no longer simply pass on higher prices and inflation falls.
When inflation rates rose in the winter, but the economic prospects before the Ukraine war were still good, some central banks resorted to precisely this measure: key interest rates were increased in Great Britain, Norway and Central and Eastern European countries. Since the Russian attack on Ukraine, however, the economy has clouded over, while inflationary pressure is increasing. In the euro area, the inflation rate reached 7.5 percent in March, the highest level since the introduction of the euro in 1999.
“This means that monetary policy is faced with a conflict of objectives between price and production stabilization,” stressed leading economic researchers recently. It is a balancing act for the central banks: if they raise interest rates too quickly or too much, the economy and the labor market could be stalled. Finance Minister Christian Lindner (FDP) is therefore already warning of the threat of “stagflation”, that toxic mix of rising prices, economic stagnation and unemployment. If even higher wages were negotiated now, it could very quickly lead to a dangerous spiral.
This is one of the reasons why Europe’s currency watchdogs are cautious about raising interest rates for the time being. Bundesbank President Nagel calls for prudence at the IMF spring meeting in Washington. “An emergency monetary policy braking, however, would not make sense,” he says. One should not turn the interest rate screw too hastily. But the European Central Bank (ECB) has had to listen to a lot of criticism for its hesitation.
US Federal Reserve Chairman: “Inflation is far too high”
In the USA, on the other hand, research is being done: the Fed has been reducing its crisis programs for the Corona period since the end of 2021, and in March it increased the key interest rate for the first time since the pandemic began – and made it clear that the plus of 0.25 percentage points was only the kick off was. Analysts even expect an increase of 0.5 percentage points to a range of 0.75 to 1 percent at the next meeting on May 4th. On the markets, increases of more than two percentage points are expected for this year alone.
The pressure is great because the inflation rate in the world’s largest economy is at its highest level in decades, which is reducing consumers’ purchasing power. In March, consumer prices rose by 8.5 percent year-on-year – the highest inflation rate since 1981. The Fed is aiming for an inflation rate of two percent in the medium term. “We will take the necessary steps to guarantee a return to price stability,” US Federal Reserve Chairman Jerome Powell promised at the end of March. “The job market is very strong and inflation is way too high,” he added.
Countermeasures are easier for the Fed than for the ECB because the US economy is growing rapidly. The unemployment rate recently fell to a low 3.6 percent, and many companies are already complaining about a shortage of workers. Should the economy slow down somewhat as a result of the interest rate hikes, this would probably be relatively easy to absorb.
In the United States, the risk of inflation is greater than the risk of a recession, argue the German economic research institutes in their recently published joint diagnosis. In Europe, on the other hand, consumption and the economy recovered more hesitantly from the pandemic, which is why economic development is less resilient.
But there are also signs of an end to the ultra-loose monetary policy in Europe. In Washington, Nagel held out the prospect that the ECB could raise interest rates as early as July – earlier than previously thought. The first rate hikes are possible at the beginning of the third quarter, he said. That can only happen when the central bank stops investing fresh money in bonds – but that may be the case at the end of the second quarter.
Nagel did not want to predict how many interest rate hikes are to be expected this year. Financial markets are expecting the ECB to raise the deposit rate, at which banks can park money with it, to zero this year. It is currently minus 0.5 percent, so the banks have to pay a kind of fee. A decision on the future interest rate path is to be made in June.
But even the most effective weapon in the central banks’ arsenal, the key interest rate, can only influence the causes of the current price increases to a limited extent. The disruptions in global supply chains, the far-reaching corona lockdowns in China, the war in Ukraine and rising energy prices do not react directly to the key interest rate. The central bankers’ best hope is that their decisions will help the inflation rate slowly come down again.