Interest rate hikes are not the answer to Europe’s inflation problem

Rising inflation throughout 2022 has led central banks to raise interest rates dramatically. Patrick Kaczmarczyk argues that rate hikes are the wrong answer to the challenges currently facing the European economy.

Eurozone inflation rates are pushing the European Central Bank (ECB) to hike rates, while economic indicators continue to fall. Nevertheless, the ECB seems determined to do “whatever it takes” to bring inflation down, even if “whatever it takes” involves a severe recession and permanent damage to the European economy.

When we look at the history of rate hikes by the ECB, we can expect that the story does not end well. In 2006 the ECB began raising interest rates throughout the troubled years of 2007-08. The cause of inflationary pressures at the time was a sharp rise in oil prices, which peaked at nearly $150 a barrel in early 2008. Tightening monetary policy by central banks triggered the outbreak of the bubble in the financial markets, which was followed by then the greatest crisis of modern capitalism. Central banks have been forced to do an about-face in their monetary policy to accommodate policymakers in their efforts to halt the collapse of the global economy.

After the financial crisis and the collapse of commodity prices, a reverse cycle set in and commodity prices began to soar again. Oil prices almost tripled between January 2009 and April 2011, food prices joined the rally (wheat prices, for example, doubled over the same period). Inflationary pressures reappeared, as the Eurozone found itself in the deeply troubled waters of the Eurozone crisis. ECB President Jean-Claude Trichet, along with some members of the Governing Council, prioritized fighting inflation over financial and economic stability – and the ECB began raising rates of interest in the midst of a new crisis. We know in retrospect that the ECB had to step in again – this time under the leadership of Mario Draghi – with another U-turn to prevent the Eurozone from collapsing.

This time it’s different?

Today, the ECB finds itself between a rock and a hard place. Throughout 2021, he argued that inflation would be transitory. The data at the time was clear: Wage growth was subdued, inflation was largely fueled by broken supply chains and, from autumn 2021, also by rising energy prices.

In 2022, energy prices continued to rise to new highs, triggered by shortages due to Russia’s invasion of Ukraine and amplified by financial speculation. Additionally, still-broken supply chains and recurring Covid lockdowns continued to disrupt global production. Therefore, we have to conclude that the sui generis and transitory factors creating inflationary pressures in 2021 have intensified and are now driving inflation into 2022. As Martin Sandbu said earlier this year, “the fact that we had an unforeseen supply shock after the other – which no one disputes – is not a reason to think that each of them is not ephemeral.

However, the longer high inflation rates persist, the more it appears that they have become somewhat permanent. As a result, the ECB finds itself under increasing pressure from policy makers, the media and the public. Although energy prices are pushing many businesses to the brink of closure and virtually all economic indicators are in free fall – indicating in part that we are headed for a bigger crisis than 2008 and the Covid pandemic -19 – the ECB finds itself forced to adopt a firm position.

Based on a sober assessment, we would have little reason to expect inflation rates to continue to rise next year. Wage growth remains subdued in the Eurozone and with companies under severe pressure due to extremely high energy prices, there is little room to negotiate large wage increases. The outlook for energy prices, the main driver of current inflation, also appears to have a smoothing effect on inflation next year, with energy futures pointing to a slight decline in prices from the second quarter 2023.

At this point, it is difficult to see where further impetus should come from for similar inflation rates next year. However, even if inflation rates were to slow in 2023, we are unlikely to have overcome current shortages, and generally high prices will continue to weigh on households and businesses. Given the magnitude of interest rate increases in previous periods in the Eurozone, interest rate increases in the current environment promise to fuel a fire that we are struggling to contain.

Different times require different approaches

In Europe, most economists agree that inflation is not fueled by expansionary fiscal or monetary policy. It’s not an overheating economy that requires some cooling. Quite the contrary: the current inflationary pressures have spread through a freezing economy. In such a context, the tightening of monetary policy is the least suitable tool to meet the current challenges.

Comparing the figures of two structurally similar economies, the Czech Republic and Slovakia, comes as close as possible to a difference-in-difference experiment to examine the effectiveness of monetary tightening. The Czech Republic raised its interest rate by 0.5% to 7% between the summers of 2021 and 2022, while inflation continued to climb from below 5% to over 17%. Slovakia, as a member of the euro zone linked to the monetary policy of the ECB, did not experience similar increases in interest rates, but its inflation fell – over the same period – from low similar from less than 5% to about 14%. It kind of confirms what board member Isabel Schnabel recently admitted, which is that the “[ECB’s] monetary policy has little impact on what happens in global commodity markets”.

While the ECB has little impact on what happens in global commodity markets, the only way monetary policy can reduce inflation is to introduce an economic slowdown. The likelihood of such a slowdown is further exacerbated by a widespread shift towards austerity. Adam Tooze pointed out that currently there are more countries tightening the fiscal screw than there were during the global shift to austerity in 2010. The German government’s very recent announcement of its €200bn to lower energy prices as well as the EU’s slightly softer stance towards debt reduction are both encouraging indicators that governments will turn away from such a dangerous turn towards austerity .

Despite the latest change, some economists still claim that if there is a supply shock, we need to adjust the level of demand downwards. However, this logic is akin to flooding an entire house to put out a fire in the kitchen. What this particular type of inflation requires, in effect, is investment to address existing shortages. Instead of lowering demand in a fragile economy, we need to increase supply. In 200 years of capitalism, if there is one characteristic that cannot be denied, it is that investment and innovation have always been the key to alleviating real shortages.

In the current environment, this is of course not straightforward and could mean that in the short term, inflationary pressures could persist. In the medium to long term, however, when investments and innovations start to bear fruit, Europe will be much better off as a society and as an economy. Opting for an austerity strategy, on the other hand, offers no solution – either short-term or long-term – to the problems we face.

How we should proceed

The most urgent investment needs are in scaling up renewables and other forms of alternative energy that we can use in the short term. The main objective of economic policy must be to increase energy supply in order to bring down energy prices. At the same time, the state must take the lead and incentivize the private sector to invest in innovations that increase energy and resource efficiency as well as the circularity of production and consumption.

These investments must complement short-term measures to stabilize household purchasing power and stem the collapse in demand that we are currently seeing. Otherwise, the political and economic fallout from this crisis will increase the cost beyond the values ​​we can put a price tag on.

Finally, the perfect storm we are facing highlights the need for international economic cooperation. So far, the response to this global crisis has been uncoordinated and risks ruining the global economy. During the Great Depression of the 1930s, countries embarked on widespread beggar-thy-neighbour policies, where each state attempted to increase its competitiveness in the face of currency depreciation. Today we are seeing the opposite, as countries pursue an uncoordinated race to the top of interest rates to reduce imported inflation by halting currency depreciation.

The tightening of the Federal Reserve has forced other countries to follow suit as high interest rate differentials and the status of the US dollar as the world’s reserve currency cause capital to flow into the United States. The consequence was a strong appreciation of the US dollar, generating higher import bills for the rest of the world, which the latter, in turn, tried to stem by raising interest rates themselves. Countries of the South, in particular, now face financial disaster as interest rates soar and dollar-denominated debt burdens threaten to choke already struggling economies.

In 1985, the United States took the initiative to correct some of the emerging imbalances in foreign exchange markets and the resulting trade imbalances. The result was the historic “Plaza Accord”, following which Germany and Japan allowed a significant appreciation of their currencies. This time, central banks and policymakers around the world are expected to come together and intervene in the currency markets in a similarly coordinated manner. This would reduce competitive pressure on who can offer the fastest and highest rate increases. Unfortunately, there is no indication that such a coordinated approach to resolving the crisis is on the horizon. International cooperation seems to be at its lowest point, just when it is so desperately needed.


Note: This article gives the author’s point of view, not the position of EUROPP – European Politics and Policy or the London School of Economics. Featured image credit: Sérgio Garcia | Your picture | European Central Bank (CC BY-NC-ND 2.0)


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