The ECB must move slowly on interest rates

The writer is a senior fellow at Harvard Kennedy School and chief economist at Kroll

The last time the European Central Bank raised interest rates, in 2011, then president Jean-Claude Trichet cited “sharp increases in energy and food prices”. The economy tanked, and the rate rises were quickly reversed. Now, food and energy prices are soaring again. This month, ECB president Christine Lagarde refused to rule out rate increases in 2022, and hawkish members of the governing council have urged quicker tightening. They risk repeating Trichet’s mistake.

Eurozone inflation has exceeded the ECB’s target of 2 per cent since the middle of last year, accelerating to 5.1 per cent in January, the highest in more than 20 years. Inflation was forecast to slow as Germany’s 2020 value added tax cut and new CO2 tax dropped out of the annual comparison. This was a surprise, and Lagarde is right to be concerned.

The problem is there’s not much she and her colleagues can or should do about it. The main driver of higher prices is energy, which accounts for just over half the headline reading. Gas prices rose nearly fourfold from June to December 2021 and jumped again this week as Russia moved into Ukraine. Roughly 40 per cent of Europe’s natural gas is imported from Russia. If Russia decides to turn off the energy taps in retaliation for sanctions, energy costs will rise further. Food prices have also lifted overall inflation.

Strip out these factors, though, and core inflation fell to a 2.3 per cent annual rate in January from 2.6 per cent in December. Even with the threat from Russia, European natural gas futures forecast prices will fall in 2023. Brent oil futures, meanwhile, suggest prices will drop from nearly $100 a barrel to $86 a barrel by the end of the year. If the futures markets are right, higher energy costs are transitory and the ECB should look through them. If wrong, elevated energy prices would weaken demand — hardly an environment in which the ECB should tighten policy.

Inflation in the eurozone has also been pushed up by supply chain disruptions. There are tentative signs these have been easing. According to Markit’s purchasing managers’ index, manufacturing suppliers’ delivery times continued to shorten in January. Sanctions on Russia could bring new interruptions, but again, that would portend slower growth, another constraint on tighter credit.

Sustained wage growth could justify ECB rate rises this year. But so far there is little evidence of this. The labor market has tightened, with unemployment at historically low levels. While employment has recovered to pre-pandemic levels, there remains a significant shortfall in hours worked because of short-term working schemes. Serious wage pressures are only likely to appear once short-term workers are reabsorbed and people start working overtime.

Negotiated pay deals play a significant role in eurozone wage growth, covering roughly two-thirds of the workforce and spanning multiple years. Unions, however, have been more focused on protecting employment and seeking benefits and flexibility than pay rises during the pandemic. HSBC research shows wage growth in pay deals dropped to an all-time low of 1.4 per cent year on year in the third quarter of 2021. This is well below 3 per cent, the level identified by ECB chief economist Philip Lane as consistent with the ECB’s 2 percent inflation target. Hefty minimum wage increases in Germany and Spain will contribute to pay growth for workers up the wage scale, but they are a one-off measure and so won’t lead to a wage-price spiral.

Finally, unlike the US, growth in the eurozone is weak. The Bundesbank recently forecast Germany will fall into recession in the first quarter. Eurozone gross domestic product remains below the pre-pandemic trend. High energy costs and Covid restrictions have dragged on consumption, and supply shortages weigh on industrial production. We should see a rebound in the second and third quarters as restrictions are dropped and new Covid cases subside, but it will be tempered by the income shock of higher inflation and energy costs.

Aggressive rate estimates for the ECB now have the deposit rate rising 50 basis points to zero per cent by the end of the year. Spreads between peripheral bond yields and German Bunds have crept up in response. The ECB must move slowly and avoid being led by the markets. Raising the policy rate won’t alleviate oil or gas supplies and premature withdrawal of accommodation could kill the recovery and reintroduce fragmentation concerns. Those who do not learn from history risk repeating it.

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