The European Central Bank (ECB) may need to raise interest rates again in June and July – on top of the expected 0.25 percentage point hike in May – if core inflation does not start falling, Dutch central bank chief, Klaas Knot, has warned.
“It’s too early to talk about a pause. For a pause, I would really need to see a convincing reversal in underlying inflation dynamics,” said Mr Knot, who was in Dublin to give the Central Bank’s annual Whitaker lecture.
While headline inflation across the euro zone cooled to 6.9 per cent in March – down from 8.5 per cent the previous month – the latest figures, published by Eurostat yesterday, indicate that core or underlying inflation, a price gauge that excludes volatile items like food and energy, rose to 5.7 per cent.
Policymakers are increasingly worried that the initial surge in energy prices has now seeped out into the wider economy, making inflation more difficult to tame.
A key concern is that service price inflation, now at 5.1 per cent, is simply too high and could be signalling that wages are becoming a key problem as services prices are predominantly determined by labour costs.
Mr Knot said he was “not uncomfortable” with current market pricing, which envisages a further 75 basis points (0.75 of one percentage point) of monetary tightening. This would feed into higher monthly repayments for mortgage holders here with the State’s 200,000 plus tracker mortgage holders likely to be hit first.
Mr Knot said the current debate over the whether the ECB should lift rates by a further quarter percentage point at its upcoming May 4th meeting or by 0.5 per cent is likely to be determined by the April inflation data, which is due just two days before the decision.
“We are now in what I would call mildly restrictive territory with policy rates but inflation is not mild. Inflation is still much too high,” he said.
“Mildly restrictive territory will not be enough to counter an underlying inflation rate that has been creeping up towards six per cent,” he said
“We need a sufficiently restrictive stance. Where is sufficiently restrictive, I don’t know but clearly not where we are today,” Mr Knot said.
The ECB has raised interest rates six times since last July to rein in inflation. The rapid tightening in credit conditions has triggered volatility on financial markets and a number of high-profile banking blowouts. Mr Knot, however, played down the possibility of another European banking crisis because of the tougher liquidity requirements placed on banks since the 2008 financial crisis.
[ Core euro zone inflation edges up in March, keeping ECB on alertOpens in new window ]
“If you combine rising interest rates with high levels of indebtedness then there are significant valuation losses and valuation gains associated with these interest rate moves...somebody must incur these losses but I’m pretty confident that euro area banks have this under control,” he said, noting that the recent turmoil on markets had gradually dissipated.
Mr Knot linked the resilience of the euro zone economy to the strength of government supports rolled out during the pandemic and the energy crisis, suggesting fiscal policy was “doing too much at the moment” and would need to be withdrawn before it becomes a driver of inflation itself.
Monster corporation tax revenues here are likely to place pressure on the Government to roll out further supports for price-squeezed households. Minister for Finance, Michael McGrath, plans to establish a new savings vehicle to divert some of the additional revenue from corporation tax.
Praising the idea, Mr Knot said he wished the Netherlands had adopted a similar policy when it discovered vast reserves of natural gas in the late 1950s.
“It was all consumed. It all went into the welfare state and I think, with hindsight in the Netherlands, we are not looking back on that decision as a very thoughtful one,” he said.
