The European Central Bank should be wary of raising interest rates too quickly

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After many false dawns, Europe’s first round of interest rate hikes in more than a decade is set to begin this summer.

The markets expect the European Central Bank to raise its interest rates by 25 basis points, or 0.25 pc, in July and by another 25 basis points in September.

Policy rates are expected to be 1.75% higher by June 2023. If these expectations materialize, this will represent another major shift for businesses and consumers to consider as a higher interest rate environment will likely affect their finances.

The ECB has been associated with crisis management since 2011 following the European sovereign debt crisis, as well as the outbreak of Covid and other shocks, resulting in negative interest rates and extensive easing programs quantitative (QE). ECB President Christine Lagarde faces a situation where growth and employment are strong and where inflation is, at 8.1%, well above the 2% target.

Ms Lagarde described the ECB’s decision to accelerate the reduction of its net asset purchases as setting the stage for take-off, saying that “we have therefore started to adjust policy so that, when the necessary conditions are met, we can take further steps towards policy normalization.” ”.

This reduction in monetary stimulus comes at a time when Europe is facing significant uncertainty and the fallout from the invasion of Ukraine. So why is the ECB so determined to normalize interest rates?

Impact of inflation

Inflation has consistently surprised on the upside for over a year now.

Central banks expected the rise to be transitory, but rising inflation persisted. Their confidence in their inflation forecasts has been reduced and they want to cut accommodation to thwart rising prices.

While much of the inflation comes from supply-side pressures, for example rising energy and commodity prices, central banks are forced to use the tools available to fulfill their mandate. of inflation. The current cost of living crisis means that politicians who do not wish to relive the 1970s support this action.

History tells us that inflation, once it sets in, is very difficult to drive out of the economy and also out of people’s minds. Central bankers fear that rising inflation will feed into price-setting and cause second-round effects.

The ECB accelerated the gradual reduction in net asset purchases, expecting to end it in early July. This opens the door to rate hikes at the July ECB meeting. The level of the terminal interest rate for this cycle is the subject of much debate and depends on the evolution of wages, inflation and growth.

Other central banks

The ECB is not alone in suppressing political accommodation. Many central banks in Eastern Europe have increased aggressively in recent months. The Czech National Bank raised its rates by 0.25 pc to 5.75 pc in less than a year and should bring interest rates down to nearly 6.5 pc. Both the Bank of England (BOE) and the US Federal Reserve have raised policy rates and signaled further aggressive rate hikes during 2022. Markets expect the BOE and the Federal Reserve respectively to exceed around 2.75% and 3% in one year.

Growth?

The ECB is aware that the risks weighing on the economic outlook are powerful. In particular, Ms. Lagarde mentioned the potential damage from high commodity prices and the impact of high uncertainty on business and consumer spending.

The cost of living crisis is felt by all and deeply affects low-income people.

US research shows that large energy shocks generally lead to precautionary behavior as consumers become more pessimistic. If growth prospects deteriorate and the impact of high inflation on wages is limited, the ECB could decide to raise its rates fairly gradually.

However, with unemployment at levels not seen since the 1970s, the ECB is sending a clear signal that it does not want to wait and see second-round effects materialize.

Implications

While the ECB and many private forecasters believe inflation will ease in 2023, recent actions by the BOE, US Federal Reserve and others suggest central banks tend to raise rates earlier and faster. when faced with this set of circumstances.

The chances of the ECB acting in the same hawkish way cannot be ruled out and interest rate hikes could be bigger than the markets currently expect.

This would be good news for savers, while a stronger euro would help reduce the cost of energy imports.

While the ECB’s crisis management era may be a thing of the past, the path to policy normalization will always present challenges for policymakers, businesses and the real economy.

Pearse Conaty is Head of Euro Rates, Bank of Ireland Markets Group

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