The ECB Has to Raise Rates, but This Is Not 2022
European economy, shows that the central bank does not need to react today as drastically as it did four years ago. But nor can it stand by without intervening, keeping interest rates unchanged while inflation continues to rise. A commentary by Lorenzo Bini Smaghi
In recent weeks, the European Central Bank has prepared the ground for the decision, to be taken on June 11, to raise its key monetary policy interest rate by 25 basis points. Financial market expectations have gradually adjusted to the sequence of statements, more or less explicit and more or less appropriate, by several members of the Bank’s Governing Council.
Financial markets now price in the increase with a probability close to 100 per cent. The following hike, of the same magnitude, is also taken for granted at the September meeting.
The central bank has accommodated these expectations by making clear that this is not, in any case, a monetary tightening comparable to the one implemented in 2022, which raised rates by 450 basis points in 14 months in response to the inflation triggered by the energy shock after the invasion of Ukraine.
The situation today is very different, in several respects.
First, compared with 2022, the impact of the energy shock is concentrated on oil, while the price of gas has so far remained contained, thanks to the diversification of supply undertaken by European countries. Electricity prices, which benefit from the investments made in recent years in renewable sources, are currently less than half their 2022 level.
The cyclical conditions are also different. Before the invasion of Ukraine, the euro area was expected to grow by about 3 per cent, due to the recovery in consumption linked to the rapid decline in the savings accumulated during the pandemic.
Inflation had been rising for months from the very low levels of the previous decade. The labour market remained tight because of the slow recovery in supply after lockdown.
In the current phase, by contrast, European growth is much weaker. Before the outbreak of the conflict, it was expected to be around 1 per cent. The labour market is not under the same pressure as in the post-pandemic phase and inflation was until recently around 2 per cent, in line with the central bank’s target.
In short, the inflationary shock of 2022 hit an economy that was already overheating. That is not the case today.
Another substantial difference concerns the economic policies that preceded the two energy shocks.
Before the invasion of Ukraine, monetary and fiscal policies were strongly expansionary. The central bank was still pursuing its asset purchase policy, or quantitative easing, with expansionary effects on liquidity and downward pressure on long-term interest rates. Monetary policy rates had remained negative since 2014.
In 2022, European countries’ public finances were being adjusted, but mainly as a result of the improvement in the economic cycle.
In short, the inflationary shock of 2022 occurred during a phase of expansionary economic policy, which amplified its impact. For this reason, a particularly drastic reversal was necessary.
Before the closure of the Strait of Hormuz, by contrast, monetary policy was in a position of broad neutrality, with short-term rates at 2 per cent, against inflation more or less at the same level. The reduction of the central bank’s balance sheet was gradually tightening financial conditions.
As for fiscal policy, the room for manoeuvre to support economic activity is now more limited than in 2022.
The comparison between the two energy shocks, and the different conditions facing the European economy, shows that the central bank does not need to react today as drastically as it did four years ago. But nor can it stand by without intervening, keeping interest rates unchanged while inflation continues to rise.
The forecasts that the ECB will publish in a few days will probably show that price dynamics will remain above 2 per cent over the next two years.
The decision to raise rates gradually therefore appears inevitable. It is reassuring, however, that this increase, fully anticipated by markets, is accompanied by a substantial stabilisation of long-term rates.
In other words, raising rates at shorter maturities makes it possible to avoid an increase in rates at longer maturities, which affect the cost of borrowing for both the private sector, households and companies, and public debt, and ultimately have a greater impact on economic growth.
A previous version of this article was published in the Italian daily Il Foglio
IEP@BU does not express opinions of its own. The opinions expressed in this publication are those of the authors. Any errors or omissions are the responsibility of the authors.
