Citadele Bank’s opinion
This week the European Central bank (ECB) made a historic decision – the base interest rates were increased in the monetary union for the first time since 2011. For months ECB was preparing the soil for the increase of rates, considering the record-high inflation in Eurozone. ECB decided to act more aggressively than previously expected, and has increased interest rates by 0.5%. Already it is clear rates will be increased again in September. However, considering the expected slowing of the economy in Eurozone, ECB refrains from giving any predictions as to how far the institution is prepared to go.
How far will interest rates will go?
The interest rate collection in Eurozone, which directly relies on decisions from ECB, has already started adapting to the brewing changes. In six months Euribor rate returned to positive levels. At the start of June it was 0.5%, which is the level it remains at now as well. The three-month Euribor rate, which is normally lower than six months, turned positive a week ago. This means borrowing in Eurozone is slowly become more expensive for young and old borrowers alike. Their contracts already include the variable portion. Financial market players expect the peak interest rate to reach 1.5-2% in Eurozone in the coming years, judging by the three-month Euribor outlook.
The outcome does not depend on ECB alone
ECB has the noble goal of reducing inflation rates in Eurozone. However, the direct influence on inflation from the restrictive monetary policy in Eurozone will be hard to notice immediately. Some time needs to pass until the effect of a tight monetary policy on demand is reflected in prices of goods on shelves or if it manages to at least limit the growth.
Unlike the US, for example, Europe has yet to reach the overheating levels of demand.
The situation in Eurozone is made more complicated by the fact that although the price rise has become comprehensive in recent months, two-thirds of consumer price rise in the monetary union still consist of energy resources and food. These prices depend on the situation on global resource markets, which is something ECB cannot influence.
Can ECB help battle inflation here and now? The answer is yes. First of all, unlike the US Federal Reserve System (FRS), ECB started raising rates nearly six months later, and it plans to raise rates in a more controlled and calm manner (FRS predicts interest rates, which are currently within 1.50-1.75% range, may reach 3.75%). This is why euro became much cheaper than US dollar this year.
Cheap euro also makes resources more expensive for Europeans that previous used US dollar for commercial purposes.
ECB’s transition form words to actions could help strengthen the monetary union’s currency and thereby reduce inflation pressure.
Secondly, the message central banks send to investors, consumers and businessmen is more important than actual measures. The commitment of the biggest central banks to battling rapid price rise with aggressive increase of interest rates without fears of slowing economic growth or even ‘flirting’ with recession has forced financial market players and economists to significantly downgrade western countries growth perspective for the coming years.
Situation on raw materials market could help dampen inflation
Since the start of summer the price of oil has gone down by about 15%. Prices of agricultural goods on global financial markets have gone down by an average of 20%. Prices of metals have gone down 20-25% and have stabilized on the pre-war levels. If this continues, this should start getting reflected in inflation numbers soon.
There are risks on the side of suppliers of energy products, which may significantly change the situation with inflation, especially in Europe.
Despite all this, it seems US and Eurozone member states may be close to the peak of inflation. Inflation should start slowing down closer to the end of the year, when base effects are expected to kick in. It was autumn 2021 when price rise commenced on resource markets. This could help make things easier for central banks and reduce the need to further increase interest rates.