What the minutes of the ECB reveal about interest rates

By Leonidas Stergiou

Perhaps the most interesting part of the minutes of the ECB’s June meeting is at the end. Where everyone agrees with the analysis of the economy and that the markets took monetary policy into their own hands by raising interest rates, thus causing the risks to growth that the ECB wanted to avoid.

But also where they disagree with the way of acting and the way of communicating the change in monetary policy, adopting the pursuit of normality and not tightening.

The decision to announce the intention to raise interest rates in July and September looks like the result of an assessment between bad and worst case scenarios. Rising interest rates create risks to the economy, markets, businesses and households, without directly hitting the root of the inflation problem. On the other hand, inaction leads to the same and greater risks through runaway inflation and a lack of market confidence in the ECB and monetary policy.

After the view gained ground that a rate hike would restore some of the ECB’s lost credibility, several members suggested a bigger hike, by 50 basis points instead of 25, in July as inflation now persists with heightened intensity. And let it be seen that the main source of evil does not come so much from the side of demand and liquidity. The decision at this point was not easy and it was evident in the discussions that followed on the formulation of the decisions.

Don’t lose control

The main problem is that the markets stopped trusting the ECB’s forecasts and stance and took monetary policy into their own hands. Once they saw increased inflationary risks and repeated misforecasts from the ECB, the market started raising interbank rates and yields in bond markets.

This move was causing the negative effects that the ECB wanted to avoid by raising interest rates that it was delaying to do. That is, fragile development will be affected, fiscal differences between member states will be highlighted, economies with higher public debt will become more vulnerable, access to finance for states, businesses and households will become more difficult and expensive, there will be a risk of correction of real estate prices and other assets, such as bonds, stocks, etc.

And all this without the ECB controlling interest rates, with inflation fueled by energy prices and the weakening of the euro against the dollar. Moreover, to be accused of inaction, misjudging the nature of inflation and mispredicting its level. At the same time, inflation itself eats away at growth and disposable income, again causing risks to the fiscal and real economy.

For every solution… a problem

The analyzes by the economists and members of the ECB went in circles and came to the same points.

The main cause of inflation is the energy crisis. Energy appreciation spread to non-energy products due to rising production costs, a strong labor market and demand supported by measures during the pandemic to avoid recession and a new financial crisis.

But global demand and the Eurozone economy are fragile enough to withstand a rise in interest rates that would, among other things, exacerbate fiscal imbalances and market risk. Inertia, again, drives funds to the dollar and the falling euro turns the 88% increase in energy prices into 111% in the Eurozone.

And the risk to the economy and markets grows as the ECB loses credibility, with criticism that it is not forecasting well and that it is slow to raise interest rates.

Messages from businesses

At the same time, inflation data was worrying, mainly from energy prices and the supply chain due to the war in Ukraine. The ECB is receiving signals for wage increases of 3-4%, above the inflation target, while another study showed that businesses can’t bear to absorb costs for long and will go ahead with price increases.

The decisions

So the ECB decided to hit at least the part of inflation where it can be effective. That is to reduce the demand. It was decided to end the bond purchase through the APP program as it was found that liquidity could not be absorbed faster. The end date of the program was agreed on July 1st.

The disagreements

There was more disagreement about interest rates. One side claimed that since the ECB finds that inflation persists, the rate hike should be higher, e.g. by 50 basis points in July. In this way, it gives the message to the market that it is now focusing on achieving the 2% inflation target and that it is determined to achieve it, strengthening its credibility. Besides, the risks from the rise in interest rates had been analyzed and among them there was that of recession. A risk that worsens in the event of further negative geopolitical developments.

The other side argued that once there is an agreement to raise interest rates, due to inflation and despite the risks, then it should be done in a way that limits those risks. For example, to announce the steps of the ECB, to make gradual interest rate increases and always based on data. Communicate the decision for normality and not for monetary policy tightening. At the same time, communicate that the risk of rising spreads has been taken into account and that this will be dealt with flexibly, through the PEPP bond purchase program or even with a new tool.

In the end, the view prevailed to announce a rate hike of 25 basis points in July – in principle – and a second one in September, leaving the size of the increase open. And generally to emphasize flexibility and data coming from inflation.

At this point the view gained ground among members who claimed that the 25 basis point rise in interest rates would give the ECB time to see market reactions and receive new data on the inflation front until September. Then he can decide another increase of 25 basis points or more. For after September, the decisions will be taken depending on the inflation data and gradually.

The TPM

Regarding the new tool for reducing spreads, it was agreed that the announcement should focus on the end of the bond program, the rise in interest rates, the steps and reasoning of the ECB. The details of the new tool would be the subject of yet another discussion.

From the minutes it appears that the risk of increasing spreads especially of countries with increased debt was discussed and predicted and that an intervention tool will be needed. However, no details about this were discussed.

According to information, the details are to start being discussed in Frankfurt this week. The name of the new tool, TPM, currently stands for “Transmission Protection Mechanism”.

Here the ECB will have to find a solution that will satisfy the provision of support where it is needed without causing reactions to moral hazards and monetary financing, putting some criteria, such as whether they are justified in the spreads by the fiscal picture, by the assessments of the budgets by the Commission, etc. That is, it will set conditions that will satisfy all sides, since as an independent monetary authority it cannot impose fiscal rules without the Commission and the ESM. Besides, such a tool already exists (OMT) since 2012 and it never worked.