The European Central Bank (ECB) announced on Thursday its decision not to raise interest rates for now, despite historically high inflation in the eurozone . However, in her appearance after the announcement, the president of the body, Christine Lagarde , refused to affirm as she had done so far that a rate hike in 2022 was “very unlikely”.
“In view of the current uncertainty, we need more than ever to maintain flexibility and optionality in the conduct of monetary policy,” said Lagarde, who, however, added that “the Governing Council of the ECB is prepared to adjust all its instruments to ensure that inflation stabilizes at its 2% target”.
These cryptic messages, which could sound Chinese to anyone uninitiated in monetary policy, are, however, crucial for the future of the European economies.
What are interest rates?
Very broadly, interest rates could be defined as the price of money. When we borrow to, for example, buy a house or finance a new car, the bank charges us an extra percentage for the risk it assumes by lending us the money. It also happens when we deposit our savings in an account. In that case, (although not always) the entity also pays us a small percentage to be able to use it.
“Just as a bank charges us interest when it grants us a loan, the ECB also requires it from the banks that come to it to borrow from its reserves”
These two everyday examples are familiar to almost any consumer, but the interest rates that Lagarde refers to and that concern investors and governments are different . Just as a bank charges us interest when it grants us a loan, the European Central Bank also requires it from the entities that come to it to borrow from its reserves. And it also pays interest when banks make deposits with it (although in recent years it has been charging them).
These rates set by the ECB at its famous meetings are called official interest rates and are its main tool for influencing the economy. When the body chooses to raise or lower them, its decision determines the value of dozens of other interest rates that operate daily in the economy.
What happens if they go up or if they go down?
The effect of the ECB’s decisions on the real economy is very complex, but it could be summarized with a diagram like the one below. When interest rates rise, the loans granted by banks become more expensive: you have to pay more for receiving the same amount. This tends to cause consumers and businesses to borrow less money and governments to pay more to finance themselves.
It is best explained by Manuel Hidalgo, professor of Economics at Pablo Olavide University and researcher at Esade. “If interest rates rise, the economy cools down. People borrow less, investment projects (in a factory, a business…) are less profitable than investing in bonds…”, he explains. As if it were a waterfall, the rise in official rates filters through all layers of the economy and ends up causing prices to fall.
On the other hand, when rates fall, the opposite happens. The economy heats up. Borrowing becomes cheaper, which incentivizes consumers and businesses to invest, makes it cheaper for countries to finance themselves, and stimulates economic growth. In the same way, the increase in spending filters down and puts pressure on prices, which go up.
Why is raising rates debated now?
The main mission of central banks is for prices to be stable, which does not mean that they do not change, but rather that their growth “is as expected and desired,” explains Hidalgo. In the case of the ECB, the objective is that, in the medium term, inflation is as close as possible to 2%.
The problem is that, after the strong recovery that the economy is experiencing after sinking in 2020, prices have skyrocketed. Year-on- year inflation is at its all-time high in the euro zone and at unprecedented levels in almost 30 years in Spain . The main culprits are high energy prices and disruptions in global supply chains.
For the time being, the consensus among analysts is that this inflation is transitory and will subside throughout the year, which will allow prices to stabilize on their own. The problem is that, in recent months, inflation has begun to affect more and more products, which could be an indication that the rise in prices is deeper than expected.
The key in this matter are the concepts of transience and persistence . If inflation vanishes soon, wages could adapt to prices more progressively and the situation would eventually balance out without damaging stability. However, if inflation persists for too long, workers will push harder for their wages to rise and not lose purchasing power. When this happens, the costs of companies -which are the ones who pay wages- also rise, which could cause companies to raise prices again, generating a spiral that is difficult to stop.
To prevent this from happening, the ECB closely monitors data on wage increases which, for the time being (at least in Spain), are considerably lower than inflation. However, as prices do not fall, the pressure to increase wages is increasing .
If there are clear signs that a spiral is forming, the ECB could announce an interest rate hike to try to stop it, but it is not easy. A miscalculated increase could cool the economy too much at a time when the European recovery is not yet consolidated.
How would this affect Spain?
Countries finance their public spending thanks to taxes, but they also turn to the markets to obtain financing, especially in times of crisis when incomes are reduced. If official interest rates are low, countries find it easier to borrow cheaply. On the other hand, when they rise, the cost of financing increases. Especially for the most indebted countries, in which investors see more risk of default.
In the case of Spain, with a debt to GDP ratio of more than 120% of GDP , a sharp rise in rates could hinder its access to the markets. Despite this, for Hidalgo, the rise that is on the table “would be very small, psychological rather than really effective.”