Twice in the past 14 years, the European Central Bank has raised its interest rates. It did not go well on either occasion.
The increase of July 2008, well into the early stages of the global financial crisis and just weeks before the collapse of Lehman Brothers, quickly looked silly: it had been a knee-jerk reaction to soaring world fuel and food prices. Within months, rates had been brought down sharply.
In April 2011, the ECB once again over-reacted to a spike in fuel prices, fearing that inflation would take hold, especially in those euro area countries that had better weathered the great financial crisis. But, even though that interest rate increase lasted for less than a year, it imposed so much stress on weaker economies that financial markets lost confidence in the ECB’s ability and determination to avoid a break-up of the currency union. The malaise was not cured until Mario Draghi’s famous London speech of July 2012 (“Whatever it takes… and, believe me, it will be enough”).
On Thursday, the ECB finally (and, according to some, belatedly) decided to raise its short-term lending rate for the first time since 2011 and has flagged that more increases will follow. Will the consequences be equally bad? Probably not.
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It is in order to avoid deflation that the ECB has been stimulating spending through ever lower interest rates for the past decade. The notion of falling prices may sound agreeable, but a general deflation is usually accompanied by economic stagnation. And that would surely have been experienced in these recent years had the ECB not persisted with its accommodating monetary policy, marked by large-scale purchasing of Government bonds as well as by negative interest rates.
The relatively sudden increase in inflation over the past year removes the need for a super-expansionary monetary policy. Indeed, the public looks to the ECB, whose mandate it is, to generate a low and stable rate of inflation over the medium term. Such easy monetary conditions are no longer needed and may now be undermining policy efforts to prevent the initial surge in inflation from spilling over into a spiral, as firms and workers quite understandably – but ultimately self-defeatingly – seek to recover lost purchasing power by holding out for higher and higher prices and wages.
Many observers have complained that the ECB has been too slow to move on its policy interest rates, but the criticism can be overdone. After all, financial markets pay attention to policy statements by ECB officials – as witness the fall in bond prices over recent months that already reflect an expected sequence of policy rate increases. That is why the Irish Government now has to pay more than 2 per cent per annum on borrowing for 10 years, whereas less than a year ago the required interest yield was negative.
Recessionary costs
Two considerations have stayed the ECB’s hand on interest rate increases. First, there is the recognition that – so far – the rising prices have not been primarily caused by excessive aggregate spending in Europe, but were triggered by external factors including post-pandemic blockages and supply imbalances, as well as the war in Ukraine. For the ECB to raise interest rates sharply and quickly could forestall an inflationary spiral, but at the cost of strangling economic activity (already weakened by effects of the war). It has to be acknowledged that, while monetary policy can bring inflation under control, the recessionary costs of doing so too quickly can be high.
Second, the still-fragile fiscal position in countries such as Greece and Italy could be tested by a too-sharp increase in the rate of interest on the government bonds of those countries. To head off this risk, the ECB has made it increasingly clear that it will use the remaining elements of its asset purchase programme to buy stressed government debt where necessary.
Although it has revised its inflation forecasts up, the ECB remains notably optimistic about inflation in 2023 and especially 2024, when it expects inflation to be back at close to 2 per cent. Its optimism in this seems to be shared by a surprisingly large number of independent analysts.
My own suspicion is that this inflation surge will be higher and longer than that, though this may partly reflect innate pessimism.
Clearly, collective action by a wide array of policy actors may be needed to try to ensure that the pain of the surge in import prices is distributed fairly and without the destructive inflationary scramble that marked the last big wave in the 1970s.
There is a further risk for a euro-area country such as Ireland, especially if the ECB does succeed in getting inflation back under control soon. In the old days, some of the potentially damaging consequences of an inflationary spiral on national competitiveness were quickly washed out by currency devaluation (inflation’s constant companion). But now, if domestic wages and prices get out of line with what is happening elsewhere in the euro area, there can be no devaluation, and the damaging effect of this loss of competitiveness on Irish incomes and employment could be severe.