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The Irish Times view on ECB interest rates: striking a balance

The ECB’s governing council is set to increase interest rates again on Thursday, but it faces difficult choices ahead as recession threatens the euro zone

An exterior view of the European Central Bank (ECB) in Frankfurt, Germany. The European Central Bank is planning further interest rate hikes this year. Picture: Shutterstock

Mon Oct 24 2022 - 21:00

The governing council of the European Central Bank meets on Thursday and is expected to announce another significant interest rate increase. Like other central banks it is responding to the sharp rise in inflation, partly due to the war in Ukraine and its impact on fuel and commodity prices.

There is no question but that interest rates had to move off the rock bottom levels which they had been at in recent years. The scale of the increase in inflation made this inevitable. However, the ECB has a very difficult balance to strike – as it increases interest rates, signs are growing that the euro zone economy is heading for recession.

The latest data shows that business activity in the euro zone in October experienced its biggest contraction in over two years. Activity levels in big manufacturing and service companies are falling and the euro zone economy may well be in recession in the final quarter of this year.

Higher interest rates will make this worse, increasing costs for businesses and hitting consumers in their pockets, thus further reducing demand. Central bankers, including those at the ECB, argue that their mandate is to control inflation and that the longer-term costs of not doing so would be even greater. They are correct that runaway inflation can cause huge economic damage. However, there is a need for balance, too, in the ECB’s response because recession would cut demand and bring down inflationary pressures. Moving too far, too fast could cause unnecessary economic pain.

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Striking the balance is difficult, because interest rate increases only feed through slowly to the real economy. The ECB will also be mindful that borrowing costs remain low and well below prevailing inflation rates. Another 0.75 of a point increase on Thursday will still leave the ECB’s deposit rate at just 1.5 per cent.

As the ECB revises its own forecasts in December, it needs to match policy to the changing outlook. Whatever it does, inflation will take time to return to its target level of 2 per cent after an extraordinary period of economic upheaval

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