Lagarde under pressure: Putin forces the ECB to raise interest rates

Lagarde under pressure
Putin forces the ECB to raise interest rates

By Jan Ganger

The Russian attack on Ukraine puts the ECB in trouble. It has to raise interest rates because inflation remains extraordinarily high, mainly due to rising energy prices. The disadvantages of such a step are enormous.

The European Central Bank has a problem: Vladimir Putin. Inflation in the eurozone seems to be getting out of hand, at 7.5 percent. This is mainly due to rapidly rising energy prices. These shoot up because of the war of aggression instigated by the Russian President. In April, energy prices in Germany rose by around 35 percent.

The threat of gas supply disruption from Russia, the switch to alternatives to cheap Russian imports, the need to fill up gas storage facilities – all of this is leading to the immense jump in energy prices that households and industry are feeling.

It will also be uncomfortable for the ECB. Because she has no choice but to raise interest rates soon. For a long time, the central bank, under the leadership of Christine Lagarde, insisted on leaving the key interest rate at zero in order to support the economy.

In fact, there were good arguments not to touch interest rates despite high inflation. The central bank assumed that the two main causes of the price increase were temporary: the disrupted supply chains would soon adjust and at the end of the heating season energy prices would fall as demand decreased. Higher interest rates would neither repair supply chains nor make oil cheaper.

In addition, a rate hike can be counterproductive and slow down the economy, even though it needs support. Higher interest rates have a price-dampening effect because they make borrowing more expensive and saving more attractive. Companies invest less, consumers spend less money. Demand falls. Another problem: interest rate increases do not take effect immediately, but with a delay. In the worst case, such a step would only take effect when the euro zone is already in recession due to a gas delivery stop by the Kremlin.

Fear of wage-price spiral

However, this does not change the fact that high inflation in the euro zone and in Germany cannot be ignored. To make matters worse, it is not only energy that is becoming more expensive. Consumer prices are rising across the board. This increases concern that the general price hike will last.

This increases the greatest danger for the ECB: the loss of credibility. For months, central bankers have asserted that the high inflation is temporary. But at the latest with the Russian attack, it becomes apparent that she is in danger of getting stuck. The fact that war and upheavals on the energy markets were not foreseeable is irrelevant. Public perception is crucial.

The rising cost of living was a dominant theme in the French presidential election, benefiting far-right candidate Marine Le Pen. This sentiment becomes a problem for the ECB if the general public assumes that inflation will continue to rise and that the central bank will do nothing about it.

Then a so-called wage-price spiral threatens. The logic behind it: Workers across all industries are giving up their reluctance and pushing through higher wages across the board. Companies raise prices to compensate. As a result, the general price level continues to rise, creating a chain reaction. The classic means of monetary policy, on the other hand, are interest rate hikes. According to the economist Achim Truger, “there is still no sign of excessive wage growth” in Germany. However, this is due to the relief packages from the federal government, which partially compensated for the inflation-related income losses of private households.

The ECB has meanwhile signaled that it will soon raise interest rates. Because of Putin’s war, she probably has no other choice. Nevertheless, the timing is extremely unfavorable: the economy in the euro zone is already losing momentum. In Germany, gross domestic product grew by just 0.2 percent in the first quarter of the year.

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