The European Central Bank’s decision to increase interest rates for the first time in 11 years came as no surprise, even if the prospect of a full half-point rise only came into view this week.
Like other central banks the ECB is scrambling to respond to inflation, but the fact that it is last to move among major central banks means a rapid pace of interest rate increases is now possible. Possible, but far from certain. ECB president Christine Lagarde indicated that the central bank wanted to see interest rates “normalise” fairly quickly.
What exactly normal is at a time of soaring inflation and slowing economic growth is anyone’s guess. Another interest rate rise in September appears likely and while the ECB will want more rises beyond that, it may struggle to deliver them if a gas crisis tips Europe into a recession. We don’t know whether this will happen, of course. The worst outcome for central banks, including the ECB, would be if growth slows rapidly but inflationary pressures remain.
Do they then continue to increase interest rates and risk a recession? Or wait for the economic slowdown to act to control price and wage pressures? There is no right answer here – it is an issue of judgment against an uncertain economic backdrop. The decision to opt for a half-point increase this time went against previous guidance from the ECB and was justified on the basis of inflationary trends.
The ECB has struggled to communicate its intentions in recent months, partly an understandable reaction to a moving target but also a reflection of a divided governing council. It is vital that a consistent message goes out in the months ahead. Changes in approach in response to circumstances are justifiable. Squabbling in public is not – and could yet undermine key policy goals in the months ahead.
Primary among the delicate targets is to try to avoid unwarranted market speculation against countries in the financial markets. Italy, facing into a general election campaign, is particularly vulnerable, given it high debt level and uncertainty now about policy. The ECB announced a new policy to try to address this, but the rules surrounding it leave it unclear which countries will qualify and how quickly it could be implemented. The market may well test the ECB’s resolve here sooner rather than later.
It remains to be seen if the governing council can respond quickly and coherently. Borrowers, meanwhile, are facing higher repayments, with more rises to come. In normal times most might absorb this, but in the midst of a cost-of-living crisis many will now find it difficult.
The ECB may have little choice but to increase interest rates, but it is an imperfect weapon at a time when it is supply factors – mainly higher energy costs – which are driving prices higher and not strong consumer demand.