The European Central Bank (ECB) raises interest rates from 0.75 to 1.5 percent, the second consecutive increase of 75 basis points. This brings the key interest rate to its highest level since 2008. At the time, the central bankers raised interest rates in a declining economy, as is now the case. As the global financial crisis intensified, interest rate hikes were quickly reversed.
It remains to be seen whether this will happen again. Unlike then, inflation is much higher than the ECB’s 2 percent target. In September inflation in the eurozone was at a record level of 9.9 percent. “Whoever thought inflation was dead now knows better,” Bundesbank chief Joachim Nagel said recently in a lecture at Harvard University. “The beast has awakened from its slumber. It’s up to central bankers to tame it again.”
Neutral interest rate
Even with the latest hike, interest rates remain below 2 percent, the estimated ‘neutral’ level at which the ECB is not encouraging the economy is still slowing down. Analysts expect the central bank to raise another interest rate in December, then by 50 basis points.
The ECB’s quest is not universally applauded. For example, Giorgia Meloni criticized the interest rate hikes this week in her first-ever speech as Italian Prime Minister. According to her, “many see this as a rash choice, with the risk of making access to credit more difficult for households and businesses.” While it is precisely the intention of the ECB to slow down the economy in this way.
Raising short-term interest rates also translates into higher interest rates for long-term loans. For debt-laden Italy, this means that the government will have to pay more interest when issuing new government bonds.
Free winnings
The central bank will further adjust the remuneration that banks receive on money they have borrowed from the ECB in the form of long-term credit, and which they then store with the same ECB. It is estimated that eurozone banks are now making 28 billion euros of ‘free profits’. That’s an unintended side effect of monetary policy that stems from a time when there was too little inflation, rather than too much. During the interest rate decision, Lagarde will provide more information about exactly what that change looks like.