The ECB's dilemma with interest rates: taming inflation at the cost of sacrificing economic recovery

The ECB’s dilemma with interest rates: taming inflation at the cost of sacrificing economic recovery

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Working as a central banker is similar, in difficult times, to the job of a tightrope walker. Or that of the doctor who must prescribe a treatment that he knows will have secondary effects on the patient, but that is the only way to eliminate a greater evil. In this case, the patient is the European economy; the ailment, inflation. And the prescriber of that bitter medicine (an interest rate hike) is a European Central Bank (ECB) that is facing a very difficult dilemma to solve: growth or inflation.

The consensus is almost unanimous among analysts. The economic picture is getting darker as autumn approaches. After a summer in which, despite inflation, everything indicates that tourism will pull the wagon of the economy, the prospects are filled with clouds coinciding with the drop in temperatures.

The word “recession” begins to sound more and more strongly among analysts and appears frequently in their forecasts. Official forecasts (ECB, European Commission, Bank of Spain…) still do not see it as the most likely scenario, but private analysts are already beginning to openly raise it and date it between the end of this year and the beginning of next.

The arrival of the cold is expected to be the most difficult in several decades for the European Union. The gas supply that comes from Russia is weak and the hypothesis of a total cut that leaves consumers and, above all, the European industry shivering seems increasingly feasible. Political instability, with a government crisis in Italy, the third largest economy in the euro, and the fragile economic recovery in a Europe besieged by relentless inflation, are anything but a favorable scenario.

To this accumulation of misfortunes has now been added the first rise in interest rates by the ECB in 11 years, which has also been the most forceful in the entire history of the euro. The monetary authority sends a very clear message with its decision to raise rates to 0.5% and that is that it takes inflation seriously. An increase that could be followed by two others of the same caliber in September and October.

The ECB has based its decision on the expectation that inflation remains “undesirably high for some time”. The main mandate of this institution is to ensure price stability and the most powerful instrument it has to do so is rate hikes.

Some increases that, although they may end up being useful to stabilize prices, also have a negative reverse and that is that end up slowing down the growth of the economy. When a central bank raises rates, what it does is make the loans it grants to commercial credit institutions more expensive and pay off their deposits better.

This ends up causing traditional banks to do the same and charge more for lending to their customers, which makes mortgages and other loans more expensive and discourages others from borrowing. It also encourages savings (deposits start to be more profitable), but slows down investment (companies start to think twice before borrowing). Over time, this effect runs through the economy from top to bottom: consumption slows down, company profits fall, and as demand cools, prices end up falling.

The problem is that too sharp an increase in rates can end up causing a sharp contraction in the economy (what in economic jargon is known as a ‘hard landing’). Something especially sensitive at a time when the eurozone has barely recovered its pre-pandemic level of GDP and when some countries -including Spain- are still far from a complete recovery.

Another of the clearest dangers of going over the brakes are the risk premiums. Rate hikes also increase the cost of financing for countries and if we add to this the fact that the ECB has decided to stop buying public debt, States will be more exposed to private investors who demand higher returns, especially those most indebted countries. The memory of the euro crisis, when the markets closed the tap on credit to the southern countries, which was about to destroy the European currency, is still very present.

But inflation that becomes entrenched and lasts even longer can end up eroding growth even more. And it would mean taking drastic measures to curb it, which in turn could inflict even more damage than a rate hike. Furthermore, the tightening of the ECB’s monetary policy could make it easier for the euro to recover some of the lost ground against the dollar. An issue that is not trivial if one takes into account that energy prices are the main cause of the current crisis and are paid in dollars in international markets.

Everything points to European countries have no choice but to swallow that bitter medicine to avoid a greater evil in the future. The question now is how strong its side effects will be and how long the treatment will last.

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