A sharp interest rate hike by the European Central Bank may lead to multiple risks.
On October 27th, local time, the European Central Bank raised interest rates by 75 basis points again, raising the main refinancing rate, marginal lending rate and deposit mechanism rate to 2.00%, 2.25% and 1.50% respectively. In addition to raising interest rates, two important monetary policy tools have been adjusted, indicating that the scale reduction has been advanced. In the past four months, the European Central Bank has continuously raised interest rates by 50, 75 and 75 basis points, and the president of the European Central Bank has stated that it will continue to raise interest rates until inflation returns to 2%. In fact, the causes of inflation in Europe are complicated and deeply rooted. Despite continuous interest rate hikes, inflation in the euro zone has not peaked. A sharp increase in interest rates and contraction of the balance sheet may bring risks such as economic recession and European debt crisis.
The causes of high inflation in Europe are complicated.
Inflation in the euro zone was not built overnight. At the end of December, 2021, the year-on-year growth rate of the consumer price index (CPI) in the euro zone quickly climbed to 5%, and this year it accelerated. In September, 2022, the growth rate was as high as 9.9%, while the year-on-year growth rate of the producer price index (PPI) in August was as high as 43.3%. From the perspective of countries, only a few European countries, such as Switzerland, still have a single-digit inflation level. In more than 26 European countries, the CPI growth rate exceeds 10%, and most European countries have high inflation. In some countries, inflation has already derailed. In September, Turkey’s CPI increased by more than 83%, hitting a new high in 24 years.
The causes of high inflation in Europe are complex and deep-rooted. The negative interest rate previously implemented by the European Central Bank and the European version of quantitative easing monetary policy make the currency overshoot a monetary factor of high inflation in Europe. European energy prices continue to run at a high level, which is an important supporting factor for higher prices; The European Central Bank’s interest rate hike lags behind that of the Federal Reserve by four months, and the import inflation caused by the depreciation of the euro caused by the appreciation of the US dollar is an important reason for this round of European inflation.
The supply shock brought by geopolitics. Geographically, the EU has just passed the eighth round of sanctions against Russia, demanding that the Russian marine oil purchased by the EU must be within the price limit, and extending the restrictions on the purchase of Russian steel and other imports. The European Union, which was highly dependent on Russian energy, imposed sanctions on Russia, de-russized all kinds of energy and restricted the import of Russian materials, which led to the rise of energy prices and the breakdown of supply chains. Many car companies began to withdraw from Europe, and sanctions against Russia became sanctions against the EU itself. Russia imposed anti-sanctions on the EU, requiring the EU to pay for Russian natural gas in rubles, further pushing up the cost of buying oil and gas in Europe. Although many European countries are looking for oil everywhere, the energy shortage has always been the sword of Damocles hanging over the European economy, not to mention the high cost of going far and near. Geopolitical conflicts continue, energy continues to be in short supply, and there is no solution to the European inflation problem.
Imported inflation makes European inflation difficult to solve. The minutes of the ECB meeting show that imported inflation and supply shocks constitute the main causes of inflation in Europe. Since the beginning of 2021, the euro has been depreciating, partly due to the expected monetary policy and the deterioration of terms of trade. The main reasons why the European Central Bank has maintained negative interest rates for many years are structural problems such as aging population and economic downturn. The COVID-19 epidemic dragged down the European economy, the epidemic improved slightly, and the Ukrainian crisis resumed. In order to promote growth, the European Central Bank always maintained negative interest rates. However, the continued aggressive interest rate hike by the Federal Reserve caused the dollar to return, and the dollar index rose sharply. The European Central Bank raised interest rates later than the Federal Reserve, and the euro depreciated to a new low in 20 years, falling below parity. The exchange rates of many European countries have fallen. Although the Bank of England has continuously raised interest rates by 50 basis points, it still can’t keep up with the aggressive rate hike in the United States. The pound has also hit a new low in 40 years. The devaluation of the currency has further triggered imported inflation, which has become a major problem in European inflation.
Aggressive interest rate hike and shrinking table restrain economic recovery
Faced with high inflation and the Federal Reserve’s interest rate hike, the European Central Bank actively and passively raised interest rates, but Europe needs to be alert to the economic recession, debt crisis and even financial crisis caused by the sharp interest rate hike.
Different from the last interest rate hike and the release of TPI tools, this time the European Central Bank raised interest rates by 75 basis points, but also took further measures in monetary policy tools. First, it raised the statutory deposit reserve ratio from 0.5% to 1.5%. The second is to raise the interest rate of long-term targeted refinancing instruments (TLTRO) by 50 basis points. TLTRO is a three-year targeted refinancing tool provided by the European Central Bank to banks. Previously, its interest rate could be lower than the policy interest rate by 50 basis points. After this adjustment, its interest rate will be even with the policy interest rate, which will increase the bank’s refinancing cost. At the same time, the European Central Bank allowed banks to repay TLTRO in advance from November, and once the bank returned it, it meant that the European Central Bank started to shrink its watch passively. Previously, the market expected the European Central Bank to start shrinking its watch next year.
When a sharp increase in interest rates meets a contraction, it may trigger a negative impact. First of all, it will directly and rapidly push up the interest rate level. The interest rate of the national debt of 19 countries in the euro zone is rising, while the national debt of Italy, Spain and Portugal holds more than 30% to 40% inside and outside the territory. The risk of European debt crisis once again enveloped Europe. The United States holds as much as 20% of European debt, and raising interest rates may trigger debt risk spillover.
Aggressive interest rate hike by the European Central Bank may not effectively control inflation, but it will definitely inhibit the European economic recovery. There is no buffer period from eight-year negative interest rate to three radical interest rate hikes, which makes the fragile European economy overwhelmed. However, the economic downturn has a high superimposed debt, and once the debt crisis breaks out, it will have a serious negative spillover effect. International institutions, such as the International Monetary Fund (IMF), have continuously lowered their expectations for economic growth in Europe, which also shows their concern. With unstable employment, declining income, high inflation and rising electricity prices, the social stability in Europe is being impacted. While the European Central Bank has substantially raised interest rates and reduced its balance sheet, the inflationary pressure faced by Europe is difficult to eliminate in the short term, while the risks of economic recession, debt, energy crisis and social risks are gradually increasing.
There are both high inflation erosion and radical interest rate hikes. Uncertainty makes it more dangerous for confidence to decline, thus making consumption decline generate preventive savings. The minutes of the meeting of the European Central Bank indicated that the PMI of the euro zone fell below 50 in the second quarter, and the service industry slowed down. In the second quarter, the euro zone economy grew by 0.8% from the previous quarter, and slowed down sharply in the third and fourth quarters. In October, the initial value of manufacturing PMI in the euro zone recorded 46.6, while the German comprehensive PMI and manufacturing PMI fell to 44.1 and 45.7 respectively, both hitting new lows since June 2020, and the economic prospects in Europe were bleak.
(Source of this article: The author of Economic Daily is Liu Ying, a member of the Board of Directors of Chongyang Financial Research Institute of Renmin University of China and director and researcher of cooperative research department)
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