The quarter-point rise in European Central Bank interest rates, announced on Thursday, was widely expected. What is likely to come next remains open to debate. The ECB was correct to leave its options open, rather than provide any hints about whether borrowing costs will rise further in the months ahead. It will hope it will not face the dilemma which a period of seriously rising inflation and falling growth would bring.
The euro zone inflation rate is now around 3.2 per cent, above the ECB’s 2 per cent target figure. This is too high for the central bank’s liking, to be sure. But it is not similar to what happened in 2022, when rising gas prices, combined with a post-Covid economic bounceback, led to euro area inflation averaging close to 8.5 per cent.
The ECB was criticised for responding too slowly in 2022 and will not want to make the same mistake twice. However, barring a sharp upward spike in energy prices, the outlook for inflation is now more subdued. A warning shot through the latest quarter point rise appears justified. But the ECB would be wise now to wait and see how inflation and growth play out. As well as acting too slowly, it has also been guilty of unnecessarily raising rates, most notably in 2011 when two increases had to be quickly reversed as Europe’s economy emerged from the financial crash.
The central bank’s primary mandate is to ensure price stability, though it also has to have regard to wider economic objectives, including balanced growth. This means that if its faces a dilemma caused by high inflation and low growth – so-called stagflation – it may still choose to increase interest rates. But it must realise that if this scenario were to emerge, raising borrowing costs would have a limited impact in any case.
RM Block
The ECB has no control over wholesale oil and gas prices or the first-round impact of these in euro zone economies as costs to consumers and businesses rise. It is not the typical situation of trying to slow a frothy economy. Rather, its current strategy is based on trying to put a lid on the secondary impact of higher prices, particularly in the services sector, by reducing demand a bit and also, crucially, influencing the expectations of consumers, employees and businesses about future inflation. In turn, this affects behaviour.
Higher interest rates have a cost, too and the ECB needs to tread carefully. Borrowers would be wise to plan for somewhat higher interest rates from lenders in the months ahead, but any rise should be modest, for now at least. Market expectations are for one, or at most two, more increases this year, but experience shows that these can change quickly. Much now depends on the unpredictable events in the Gulf, as ECB president Christine Lagarde said yesterday. Until this becomes clearer, the ECB would be wise to continue to hedge its bets.
