Higher ECB interest rates a masterstroke, but also a gamble

When she takes another step of 25 basis points in September on the journey as ECB president Christine Lagarde calls the exercise, the trip is not over. We can assume that interest rates will continue to rise even after that, whether or not that actually happens, how quickly and to what extent, depends on the development of inflation by that time.

With regard to the intention to raise interest rates in September, the bank does not rule out a step of 50 basis points. If inflation estimates in that month point to even faster price increases in 2024 than at present, that giant step is very possible. Lagarde not only called inflation undesirably high – you could also say she could have said something else with more than 8% inflation while the target is 2% – she also pointed out that inflation is visible in more and more places in the economy .

As every year in June, the ECB economists presented the bank's board with new estimates for economic growth and inflation up to two years ahead. After 6,2% this year, monetary depreciation will be 3,5% next year according to their forecast, followed by 2,1% inflation in 2024. Knowing that the ECB's track record in inflation estimates is simply lousy – predicted time and again the bank has seen a decline in inflation and time and again price increases have been noticeably higher in recent times – should seriously consider a significantly higher inflation rate in 2024. My own assumption is that a percentage of between 2 and 3%, if not a little bit more.

ECB inflation estimates not exactly accurate

As a result of all this, the bank decided to stop buying government and corporate bonds as of 1 July and to raise interest rates shortly. It is a masterful move by the ECB. The bank is eager to restore the trust in her that has eroded in recent years. The current high inflation gives the bank the opportunity to achieve this by demonstrating by deeds that it is fighting against the high inflation. There is only one way to do this and that is by raising interest rates.

Strong headwinds for economic growth
The problem is that a large majority of the board does not want to raise interest rates, that group would be content to keep the interest rate policy unchanged. On the one hand, due to the increased chance that economic growth will face strong winds – the World Bank recently even warned against a prolonged period of stagflation – and, on the other hand, due to the fact that the debts in too many euro countries are too high. Rising interest rates can then cause problems. And so the bank appears to be faced with an impossible task: to regain confidence, it must act decisively against high inflation. But that is at odds with what a majority of the board actually wants to do.

And yet in 2022 this impossible to solve problem can be solved. How? By deploying the interest rate hikes necessary to regain confidence and then making it dependent on the development of inflation (estimations) in the autumn of this year. The ECB is well aware that much of the current high inflation is caused by temporary and statistical factors and thus begins to fall out of the figures over time. As things stand now, that will start to play out after the summer. In other words, there is a good chance that inflation will peak in the second half of the year.

This is also reflected in the expectations of the ECB economists, who see monetary depreciation falling as the end of the year approaches. Something that will continue into 2023. Note that this trend seen by the ECB models could simply imply that the inflation estimate for 2024 could turn out lower in September than in June. Given that the June 2024 estimate is now 2,1%, a lower figure could by definition bring expected inflation in line with the ECB's target rate in the medium term.

ECB remains as dovey as can be
If the situation does indeed develop along those lines, the ECB will start showing its teeth with two successive rate hikes in July and September and then, pointing to the peak inflation rate and its slow decline, to moderate expectations about the extent of rate hikes afterwards. . Especially if by then economic growth slows down. But that the bank did not shy away from raising interest rates, that has been demonstrated by that time. That the changed situation on the inflation front took away the need to (firmly) continue after September, well, that is the case. But no one can say that the ECB has shown no will to continue the interest rate trip that has started.

The biggest risk for the bank is, of course, that inflation will not peak in the second half of the year for whatever reason. But the bank will tackle that problem by then, if it arises. Hidden behind the apparently impressive verbal hawkish violence on the part of the ECB is the fact that the bank's monetary policy remains as dovey as it gets. Even if the ECB raises the official interest rate by 75 basis points to 0,25% in July and September, this will remain well below the neutral interest rate level. That is the interest rate, at which inflation is stabilized at around 2%, neither fueled nor slowed down. In the eurozone, according to current estimates, that interest rate is roughly between 2 to 3 and 3,5%. In other words, even after interest rate hikes in July and September, the ECB will pursue an inflation-promoting policy, albeit slightly less inflation-promoting than before.