The European Central Bank (ECB) has underestimated the inflation trend, according to the Institute for German Economics (IW). With an inflation rate of 8%, negative interest rates can no longer be justified. The ECB has now decided to raise the key interest rate by 0.25 percentage points. However, high key interest rates do not help against high prices due to the breakdown of supply chains and Russia’s war against Ukraine.
The ECB ‘s primary objective is to ensure price stability in the form of 2% annual inflation in the medium term. At present, this target is not achieved by 6 percentage points. High price increases are mainly found in basic goods such as food and energy. This causes headaches in many people. But there is also legitimate concern that the ECB should now raise interest rates sharply to reduce inflation again. But this could push the economy into recession and increase unemployment.
Turn to monetary policy
The ECB is reacting cautiously: the key interest rate is set to rise by 0.25 percentage points in July. This is the first interest rate hike in eleven years: In 2011, the ECB had a negative experience with interest rate hikes. He then raised interest rates prematurely and then was forced to lower them again due to the risk of recession. Today, however, the situation is different: monetary policy has been too expansive for too long. Believing that high inflation rates were only temporary, bond markets continued and the exit from the low interest rate phase was delayed for too long. Higher interest rates are not helping the current price drive – supply chain disruptions due to China’s zero-deficit policy and high energy and food prices due to Russia’s war in Ukraine.
Lower mobility and padlocks have led many households to spend less and save more during the first year of the pandemic. So the Germans were willing to spend more money on vacations and consumption last year. A timely normalization of monetary policy would have mitigated this upward pressure on prices.
However, the withdrawal of the expansionary monetary policy does not put a brake. There is a risk that inflation will spiral out of control. Military rearmament, reconstruction of devastated Ukrainian cities, and efforts to become independent of Russian energy imports will continue to drive demand for goods for a long time – and with it prices. Cost pressure determines price developments for final consumers.
Higher interest rates do not offset the loss of purchasing power
An increase in interest rates would end the period of negative interest rates and penalty interest on savings deposits for private households. However, the situation of savers will not improve significantly at the moment: inflation rates are still too high and interest rates too low to offset the loss of purchasing power. However, further interest rate hikes are expected this year and next. By the end of 2023, interest rates could once again exceed 1%, while inflation could also reach the 2% target by then.
Source: Capital
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