7th Dec 2022

ECB raises rates despite political backlash

  • (Photo: Council of the EU)
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The European Central Bank (ECB) raised interest rates by another 0.75 percent on Thursday (27 October) despite opposition from French, Italian and Finnish leaders.

"We took today's decision and expect to raise interest rates further to ensure the timely return of inflation to 2 percent," ECB president Christine Lagarde said.

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French president Emmanuel Macron's recently criticised further rate hikes saying it may "shatter demand" and worsen the recession. Incoming prime minister Giorgia Meloni called looming rate hikes a "rash choice."

"There is something seriously wrong with the prevailing ideas of monetary policy when central banks protect their credibility by driving economies into recession," Sanna Marin, Finland's prime minister, recently tweeted, quoting an article by a Finnish academic Antti Ronkainen.

When asked about the political blowback, Lagarde said, "we have to do what we have to do. We have to focus on our mandate. And our mandate is price stability."

"Is that to say we are oblivious to the risk of recession? Obviously not. And obviously, we are concerned about those with a low income who are vulnerable to inflation," she said.

Higher interest rates, however, are a tool the bank primarily uses to drive down wages and increase unemployment which will, in turn, lower demand. It will also increase the cost of mortgages, directly affecting homeowners' ability to spend, which further lowers demand.

It is unlikely higher interest rates will offer short-term relief to low-income households struck by rising cost of living. And as Lagarde has said in the past higher interest rates will also not directly affect the cause of inflation, which is "mainly driven" by high energy costs and has also increased the cost of fertiliser and food.

Average EU inflation hit 9.9 percent in September, and clocks in at 4.8 percent excluding energy and food.

Thursday's announcement is instead meant to signal to financial markets the bank is determined to bring down inflation to its target of 2 percent.

"Too high inflation for too long can damage a central bank's credibility," ING chief economist in Germany Carsten Brzeski wrote on Thursday. Loss of credibility causes uncertainty on markets.

In a matter of months, the ECB has hiked interest rates by a total of 2 percent, the sharpest and most aggressive hiking cycle ever.

There was, however, some unclarity in how far the bank is willing to go to achieve the target of 2 percent inflation.

One determinant is the so-called neutral rate, a level of interest that does not support or dampen economic activity but instead is associated with low inflation and full employment.

It is a concept that some financial analysts have criticised as flawed as basis for policy because it is an "invisible moving target." Others have said it does not exist.

Lagarde on Thursday simply described the neutral as being "evasive."

"We have decided that more rate increases are in the pipeline, but at which pace or to which level I can not tell you," she said.

With ECB policy not directly addressing the causes of inflation nor making it evident to what level it will restrict economic activity to achieve its inflation target, some financial commentators were left confused.

"I still don't understand how the ECB can conduct monetary policy if it doesn't believe in its own inflation projections nor in any estimates of a neutral interest rate," Brzeski tweeted shortly after the announcement.

In the meantime, Europe's watchdog for systemic economic risk, of which Lagarde is also the president, recently issued its first "general warning" for financial stability since its creation in 2010.

The report highlights the increasing costs of mortgages as a systemic financial risk. "We have to be very vigilant because we know in a remote corner of the economy [financial instability] could become amplified by interest rates," ECB vice president Luis de Guindos said.

On 16 November, the ECB will release its annual financial stability review.

ECB says more rate hikes to come

European Central Bank president Christine Lagarde said more rate hikes will come, but also admitted a recession will not lower inflation — leaving some economist question the logic of the policy.

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