Hiking events

Rising interest rates in Europe won’t solve inflation, only an end to war, pandemic and supply chain disruptions will

The US central bank raised its key rates by 0.25 percentage point; further rate hikes are expected this year. Should the European Central Bank follow the Federal Reserve in rapidly and significantly raising interest rates, as some economists and policymakers are advocating?

In fact, several good reasons justify a more expansionary monetary policy in the euro zone than in the United States.

Blunt instrument

Over the past year, inflation in the United States has been consistently much higher. Admittedly, in recent months annual inflation in the Eurozone has also been above the ECB’s 2% target. But rising US inflation covered a wider range of goods and services. In the euro zone, energy prices are drive inflation much more, mainly due to the geopolitical and economic consequences of the events in Ukraine. A hike in the policy rate would not be an effective tool to influence energy prices: rather, it would cause widespread collateral damage in an economy already affected by the war.

In any case, the central bank cannot immediately control inflation in this way. A rise in interest rates makes borrowing more expensive; companies reduce their investments and consumers spend less; economic growth and employment are slowed; this then reduces wage growth and inflation. The lag can be up to 18 months. Raising interest rates is therefore a blunt instrument both in its timing and in its targeting.

Some manufacturers have used this constellation of high demand and insufficient supply to raise prices significantly.

The prices of durable goods change more quickly than those of services; they also rely on complex global supply chains. Spending on durable goods has increased during the pandemic: high-income households have bought new cars, furniture, bathrooms, etc., while customers have stayed away from restaurants, concerts and other services. Meanwhile, their supply has been disrupted by lockdowns and other measures – with no lasting change in sight, given the global prevalence of the Omicron variant and recent lockdowns in Chinese megacities supplying the tech sector.

Some manufacturers have taken advantage of this constellation of high demand and insufficient supply to significantly increase prices, while service prices have remained much more stable. Again, interest rate hikes are not appropriate to deal with such relative price changes.

In the eurozone, there is also no sign of the wage-price spiral feared by many: wage growth has recently been only 1.6% year-on-year. Even if we assume that wages will increase further this year, their growth would need to double to 3% (assuming typical productivity growth of 1%) to make a difference to the ECB’s inflation outlook.

Attenuated demand

A wage-price spiral is more worrying in the United States – less affected by the war in Ukraine which will dampen economic activity in the Eurozone and thus militate against a generalized acceleration in demand-driven inflation. The US labor market is buzzing due to the fiscal policy pursued by Joe Biden’s administration to recover from the Covid-19 crisis, which is much more expansionary than in the euro zone.

Short-time work was not rolled out in the United States to fight the pandemic and layoffs increased, but a wave of hiring quickly followed. As a result, nominal wages in the United States are rising dramatically in some industries as companies compete for workers.

The most effective anti-inflationary measures are outside the purview of central banks. They’re lying to get a global grip on the pandemic, end the war in Ukraine, and fix supply chain issues.

In the context of the still recent crisis in the euro zone, particular caution is called for when considering a tightening of monetary policy. Interest rates on government bonds in Italy and some other eurozone countries could rise sharply and sharply, given the major uncertainty in financial markets. And a contagious panic could set in on the bond markets, even if the rise in interest rates were rather weak. To avoid the fragmentation of the euro zone, this could force the ECB to again increase its bond purchases, whereas it has just decided to reduce them significantly.

Effective measures

The most effective anti-inflationary measures are outside the purview of central banks. They’re lying to get a global grip on the pandemic, end the war in Ukraine, and fix supply chain issues. Governments have an important role to play in fighting inflation, for example by monitoring supply chains and strengthening competition policies to counter price fixing and profit-price spirals involving powerful firms in the market. market. As long as the war pushes up energy and food prices, further compensatory measures by governments will be needed for low-income households, which are particularly affected by the price increases.

Interest rate hikes by the ECB remain an option going forward — should higher long-term inflation expectations or a wage-price spiral become more realistic. But there is no evidence that this is happening, and targeted tax and regulatory policies can help prevent it.

In the current context of the war in Ukraine, there are great economic and political uncertainties. The overall economic situation in the euro area is meanwhile considerably more fragile than in the United States. In this context, it would be a mistake for the ECB to imitate the Fed’s interest rate hike.

This article originally appeared on Social Europe.