Interest rates and inflation – the search for the ‘sweet spot’
On paper, the job of a Central Bank Governing Council sounds fairly straight forward.
Maintain price stability and ensure the stability of the financial system.
The guiding principle for the first is to keep the annual rate of consumer price increases to around 2%.
Sounds achievable, but that is much easier said than done, as the past few years have proven.
Are Central Banks – and the European Central Bank in particular – any closer to achieving that objective and how far will they have to go with interest rate hikes to get us to that point?
Hitting the bullseye
The target of 2% price growth has remained elusive for many years as far as the ECB is concerned.
Up until recently, the challenge for the regulator was in fact stoking inflation to try get it back up to the desired level.
It attempted to achieve that by cutting interest rates to rock bottom and injecting billions of euro into the financial system – a process known as Quantitative Easing – in an effort to get people to part with their cash, and in the process, stimulate pricing.
The flow of cash was turned to the max during the pandemic as Central Banks were keen to demonstrate that they would not be found wanting when it came to supporting economies through the period of public health restrictions.
That all ended suddenly as restrictions began to be lifted and the reawakening of the global supply chain system saw prices for commodities and products, that were getting increasingly scarce, steadily rising.
Add to the mix the war in Ukraine and subsequent energy price rises that precipitated an inflationary surge, the likes of which we hadn’t seen since the 1970s.
On the descent?
Having exceeded 10% across the eurozone in October, the annual inflation started to ease towards the end of last year.
But, as Central Bankers and economists consistently warn, it’s not all downhill on a smooth, steady path.
Inflation has a tendency to be ‘sticky’ and we’ve seen that in the most recent data coming of the euro zone.
German inflation actually increased again in June having been on the way down in the prior months, although it may have been largely down to so-called ‘base effects’ arising from the decision by the German Government to introduce fuel price increases and reductions in rail fares to assist people with the cost-of-living squeeze in June of 2022.
That had the effect of artificially dampening the figure in the month.
While the overall rate of inflation dropped further here in the month of June, core inflation – the measure that has had the ‘noise’ of fuel price and food removed – rose from 6.8% to just over 7% with higher mortgage interest rates and higher air fares to blame.
Inflation stuck at above 5% would present a real challenge for the European Central Bank.
It gives heft to the argument of some Governing Council members that the bank should continue to drive rates higher to try to force inflation back to more desirable levels.
However, there are those who argue that the rather blunt instrument of rate hikes takes a while to take effect and a ‘wait and see’ approach might be a better path to take.
Nonetheless, it’s regarded as a virtually certain that the bank will raise rates again later this month bringing the base rate (the deposit rate) to 3.75% and the main borrowing rate to 4.25%.
Speculation is already turning to September and the prospect that the bank may increase rates again before calling a halt to the current hiking cycle.
But then again, several months – and indeed several rate hikes – ago the prevailing belief was that the bank would stop increasing when the base rate hit 3%.
“The ECB is likely to remain stubborn despite some encouraging news on inflation front,” Bert Colijn, Senior economist for the eurozone with ING noted.
He agreed that another increase this month was virtually guaranteed.
“We expect another hike in September as they change tack and are now looking at this from the point of view that it is worse to do less than to do too much,” he explained.
The minutes of the latest meeting in June back this view up.
They show that the regulator believed that while inflation had started to fall, “it was widely felt that there was as yet no sufficient or convincing evidence to confirm a turning point”.
Many economists and commentators are of the view that inflation will drop rapidly now that it’s on a downward path.
Earlier this week, the Governor of the Central Bank of France, Francois Villeroy de Galhau, gave what he called his ‘commitment’ that euro zone inflation would return to 2% for 2025.
Next year, inflation is expected to decline to 2.5% on average, he told French radio.
Mr Villeroy, who is a member of the ECB’s governing council, also said that interest rate hikes were close to topping out, but that rates would be kept at elevated levels long enough for the impact to feed through the economy.
Ireland’s Finance Minister has previously spoken of the probability that inflation would fall back quite rapidly.
Michael McGrath told the Institute of Taxation annual dinner in February that inflation would likely average at between 4 and 5% here this year.
That was down from a previous Department of Finance forecast of 7% inflation for 2023.
While some argue that the bank cannot deal with both of its pillar objectives in isolation, others say it can indeed pursue price stability without risking financial stability.
ECB President Christine Lagarde stressed earlier this year that she saw no trade-off between the two.
She was speaking in the wake of the collapse of Silicon Valley Bank (SVB) in the US and the effective contagion that saw Credit Suisse coming under sustained pressure, precipitating a forced merger with rival UBS.
The driving force behind the financial market turmoil was the rapid change in the interest rate environment that resulted in a sustained drop in the value of bonds held by banks.
Nonetheless, within days of SVB’s collapse, the ECB pressed ahead with a signalled 0.5 percentage point increase in interest rates.
That was a measure of the seriousness with which the ECB is taking the task of tackling inflation.
ECB President Christine Lagarde
There may have been something of a gamble in that move. Had it precipitated further financial market turmoil, the bank could have been forced into an embarrassing climbdown on its rate hiking path.
Should signs of strain in the financial system re-emerge, or should the euro zone economy – not exactly in rude health – take a turn for the worse, could they be forced into a reversal yet?
There certainly is precedent. Having hiked rates in response to the onset of the global financial crisis in July of 2008, the ECB was forced to backtrack later in the year.
The ECB will point to the current strength in the labour market, wage growth and the nub of the problem as it sees it – persistent inflation – as reasons as to why it will not be deflected from its path now.
The reality is that it would take a seismic shift in the economic and financial outlook for it to do an about-turn.
In Europe, at least, we’re likely in for a lengthy period of elevated interest rates after around a decade of the exact opposite.
We’re not on our own in this inflationary dilemma.
The ECB, in fact, was relatively late to the game in raising interest rates with their counterparts in the US and UK well ahead.
The US Federal Reserve opted to pause its rate hiking cycle in June giving way to heightened speculation that perhaps it was at the end of the path.
But Fed Chair Jerome Powell was keen to hammer home that it was merely taking a break. It was not ‘mission accomplished’ as far as the fight against inflation was concerned.
Fed watchers are pencilling in another quarter point hike in July and, much like the situation in Europe, the likelihood of a repeat in September is regarded as high.
In the event of both coming to pass, it would bring the base rate in the US to a range of 5.5 to 5.75%.
In the UK, inflation remains stubbornly high at around 8%, according to the latest figures.
This week, a key mortgage rate in the UK hit its highest level in a decade and a half, surpassing the level reached in the aftermath of the Truss administration’s mini-budget last September.
The average rate of a two-year fixed deal stood at 6.66%, according to figures from data provider Moneyfacts.
It means mortgage costs are now at their highest level since August 2008 during the global financial crisis.
Many believe further interest rate hikes are inevitable in the coming months meaning further pain ahead for mortgage holders in the UK.