How credible is the ECB’s fight against inflation?
Last spring, in the face of rising inflation, many financial experts criticized the ECB’s cautious interest rate policy and called for key interest rates to be raised. Since 2011, the ECB has pursued an expansive, loose “dovish” monetary policy, and since then there have been no interest rate hikes in the euro area. In 2016, the key interest rates were even lowered to 0 percent. In June 2022, this was followed by the turnaround to a “hawkish” monetary policy, which primarily pursues the goal of stable inflation. The central banks were forced to react in order not to lose their credibility, because, in addition to maintaining monetary stability, one of their most urgent tasks is to keep an eye on the overall economy and employment. The ECB’s Governing Council announced that it would decide on gradual interest rate hikes starting in July. Since then, it has faced the difficult decision of finding the right balance. It has set itself the goal of reaching a target of 2 percent inflation in the medium term. Record inflation, which was at times some five times higher than the ECB’s inflation target, is and remains a good argument for raising the key interest rate despite the considerable risk of recession within the already weakening European economies.
Most recently, the Governing Council decided in February to raise the ECB’s three key interest rates by a further 50 basis points each. Accordingly, the interest rates for the main refinancing operations as well as the marginal lending facility and the deposit facility are now 3.00 percent, 3.25 percent, and 2.50 percent respectively. Further hikes are planned to achieve a sufficiently restrictive level to ensure a timely return of inflation to the 2-percent medium-term objective. The Governing Council assumes that a restrictive interest rate level will lower inflation over time by dampening demand. Many central bank heads support the hawkish course.
In January, it turned out that wages in the eurozone are rising faster than expected. However, this basically positive development could further drive up inflation, which is already high. Therefore, ECB President Christine Lagarde had already announced a further increase of half a percentage point for the February meeting of the ECB’s Committee of Governors to avoid a wage-price spiral. Due to the shortage of qualified labor, companies do not want to lose their employees and are willing to pay correspondingly good wages. ECB Chief Economist Philipp Lane estimates that it will take several years for wages to fully adjust to the recent shocks. The expected slowdown in the eurozone and uncertainty about the economic outlook are likely to put downward pressure on wage growth.
For now, current developments seem to prove the Governing Council’s decisions right: inflation in the eurozone has fallen back to single-digit levels. In Germany, the inflation rate in December 2022 was +8.6 percent thanks to the December emergency aid. In November 2022, it was +10.0 percent, in October +10.4 percent. In view of the exceptional uncertainty, the experts of the Eurosystem have revised their inflation forecasts significantly upwards. Inflation is expected to fall from an average of +7.9 percent in 2022 to +6.3 percent in 2023 and +3.4 percent in 2024. The experts do not expect inflation to reach 2.3 percent until 2025. It remains to be seen whether the world’s most “hawkish” central bank on paper will manage to achieve the primary target in the medium term.
In this context, we recommend reading our blog post (only available in German) from July 1, 2022, again, which addressed the question of whether interest rate hikes can stop inflation.
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