Why the ECB is not raising interest rates while seeing inflation

By Leonidas Stergiou

“Inflation, inflation, inflation.” inflation, with voices coming mainly from Germany pushing for more drastic measures, at a time when unions are calling for a 4% increase.

Inflation may not have been officially on the agenda of the ECB’s two-day conference, which ends today, but it has dominated open panel discussions, official interviews and forum postings. The conclusions were clear:

First, the ECB has not discussed or is discussing limiting quantitative easing, ie some kind of tapering, as in the US and Britain.

Second, the ECB, although it does not rule out that inflation may reach or exceed 4%, temporarily, does not see an increase in interest rates at least until 2024.

Third, the ECB ‘s decisions on inflation, in terms of interest rates or the bond purchase program, are not limited to rising prices, but also to the risks that may arise to growth, employment, consumer confidence, banking system, public debt, private investment, income inequality, real estate market, etc.

Fourth, the ECB does not take into account the “tests” that markets can give it, nor the voices that call for measures just to contain prices, ignoring other risks, such as growth.

Fifth, wage increases should take into account productivity rather than a temporary increase in inflation, given the debate over 4% increases in Germany. Lack of productivity and competitiveness will lead to permanent inflation.

It prefers inflation to stagnant inflation

From all the analysis and speeches, it is clear that the majority of ECB members and economists believe that inflation and any increase in market returns are not a problem as long as the growth rate is higher. Especially when inflation is believed to be temporary. Or at least medium-term. Because if bond markets are reduced and interest rates rise, then growth is hit, which may be higher than expected, but remains fragile. If the cost of money grows faster and higher than the growth rate, then the Eurozone will enter stagnant inflation, with first victims of high public debt, such as Greece, as it will not be able to increase GDP to finance debt. Also, low inflation limits the action of fiscal measures (as each restriction acts as austerity that further restricts growth and creates a reduction in inflation, as in the era of the memoranda).

“Liquidity trap”

If interest rates rise, the vast liquidity that exists today, instead of being channeled into consumption or investment, will be trapped. Already, with zero or negative deposit rates, the savings accumulated in the period 2020 to date, with difficulty pass into the real economy either through consumption or through investment. This will become more difficult to unlikely if interest rates rise and there is financial stagnation or recession. Stagnant inflation or the “liquidity trap” postpones any investment and economic activity, which is replaced by savings.

Conversely, when interest rates are zero, the appetite for savings is reduced and investment and lending are encouraged. Especially when inflation rises, savings become more unprofitable, while the relative cost of borrowing decreases. There is an incentive to consume or buy, for example, a property today, rather than tomorrow at a higher price. Still, the private sector as it sees increased demand (due to growth) and low supply (inflation) is motivated to invest in order to take a “position” in supply.

The ECB can therefore temporarily tolerate inflation reaching 4%, as concerns about a prolonged resurgence in demand will help motivate the workforce and private capital to return to the productive process and make productive investment.