The European Central Bank has refrained from another jumbo rate hike of 75 points, but is still serious about fighting inflation. Inflation is still a whopping 10 percent. For 2023, the ECB announced further large rate hikes.
ECB President Christine Lagarde has declared war on inflation and surprised the financial markets with her determination.
In 2022, inflation has hit hard. In the euro area it is currently 10 percent, in Germany at 11.3 percent (according to the German calculation method 10 percent) and in the Baltic States even at 20 percent or higher for six months. That hurts people. With annual inflation of 20 percent, the purchasing power of money halves in three years, with 10 percent in just over six years.
According to the latest forecasts by the European Central Bank (ECB), inflation in the euro area will average “only” 8.4 percent for the year as a whole and 6.3 percent in 2023. But the sample calculations show the serious consequences of very high inflation. Experience has shown that it also hits the poorest part of the population and the middle class hardest.
The ECB reacted too late to inflation
In the meantime, however, the ECB has apparently recognized the signs of the times and is getting serious about fighting inflation. On Thursday, the central bank raised its key interest rates significantly for the fourth time in a row, this time by 50 basis points. Measured against the deposit rate, the key interest rate is now at 2 percent and the main refinancing rate at 2.5 percent.
In addition, the Governing Council of the ECB announced that it expects key interest rates to continue to rise due to the fact that the in-house economists have revised inflation forecasts upwards again. During the media conference, President Christine Lagarde formally swore to the media representatives on site and the financial market participants at the computer screens that interest rates in the euro area “must rise significantly and at a steady pace in order to reach a sufficiently restrictive level that ensure a timely return of inflation to the medium-term 2 percent target».
So far, market participants had assumed, based on the futures market rates on the euro money market, that the ECB would raise the key interest rate to 3 percent in 2023. Lagarde rejected this expectation and tried to get the financial market players in the mood for a significantly higher end mark (terminal rate) for the key interest rates. On the European stock exchanges, this led to a significant expansion of the price losses that had already occurred in the morning.
The central bank now also expects a short and mild recession for the euro zone. According to their calculations, the economy will shrink by 0.2 percent in the current quarter and by 0.1 percent in the first quarter of 2023. For the year as a whole, however, the economists expect growth of 0.5 percent. However, in the past few weeks, ECB representatives had already hinted that a mild recession would not be able to curb high inflation in the long term. Unemployment in the euro area is still at a record low level of 6.5 percent, which gives the ECB some room for manoeuvre.
The ECB also announced that it intends to further reduce its balance sheet in the coming year, which would withdraw further liquidity from the markets. From the beginning of March, the bond holdings from the general securities purchase program (APP) are to be reduced “at a moderate and predictable pace”. To this end, the euro system, i.e. the ECB and the national central banks, should no longer fully reinvest the funds from expiring bonds (repayment amounts). By the end of the second quarter, the ECB intends to reduce the APP holdings by 15 billion euros per month. This corresponds to about half of the funds released.
The main mandate is price stability
The European Central Bank (ECB), whose main mandate is to maintain price stability, started the fight against high inflation very late, namely only in July, when inflation was already at a whopping 9 percent. The ECB sees price stability as guaranteed in the medium term with an inflation rate of 2 percent. This value has been exceeded many times over in some cases over the past year. Even just before the Russian invasion of Ukraine, inflation in the euro area was around 7 percent. Soaring energy prices as a result of the war then fueled inflation further.
In July, September and October the ECB increased its interest rates by 50, 75 and again 75 basis points and in October also gave commercial banks in the euro area incentives to repay subsidized ECB loans early. This process has now begun, which has already led to a small reduction in the ECB’s balance sheet total, which at times had reached almost 9 trillion euros.
No reason to give the all-clear on inflation
Despite the numerous measures taken by the ECB to combat inflation, it is much too early to give the all-clear for a number of reasons. Firstly, with interest rates now at 2 percent, according to some ECB Council members, the neutral interest rate level has only been reached, at which the economy will neither be stimulated nor slowed down. Some observers suspect the neutral interest rate, which cannot be measured, to be closer to 3 percent. Monetary policy is therefore currently neutral at best and not yet restrictive, which would probably be appropriate given an inflation rate of 10 percent. Second, producer and producer prices continue to show enormous double-digit growth rates, which will only be reflected in the general level of inflation in the medium term.
Thirdly, the ECB must be careful that the inflation expectations of people in general and market participants in particular do not deviate too far from their inflation target of 2 percent, because then the ECB would lose credibility. This process has already begun and is being followed with great attention. And fourthly, the dreaded wage-price spiral could get under way due to the high inflation, which would further fuel inflation. So far, wage deals are still contained, but this could change if inflation remains far too high on a persistent basis.
Key interest rates are likely to reach 3 percent
In view of these challenges, according to Lagarde, the ECB will resolutely continue its rate hike cycle at the beginning of next year before taking a break. In a similar situation to today, a number of central banks gave up their fight against inflation too early in the 1970s, which then took revenge. In Germany, the inflation rate in 2022 and 2023 is likely to be at least 8 percent. This means that the purchasing power has been reduced from 50,000 euros to a good 42,000 euros in just two years.
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