Emeritus Professor Joe Nellis is Head of Economic Research at MHA, the accountancy and advisory firm.
Inflation in the Eurozone has edged higher again, rising from 2.9% in July to 3.3% in August. This is a cause for concern – reinforcing worries that price pressures are proving more stubborn than policymakers would like and raising concerns that interest rates may have to rise again in the near future.
But does the European Central Bank have to act now? Having already raised interest rates in June, rising inflation adds weight to the case for another hike in September. On the one hand, this is due to short-term economic shocks. Energy prices have significantly increased in the last six months as a result of the Middle East crisis, and clearly a resolution to the ongoing conflict would bring welcome relief for the European economy. If this is just a temporary spike in prices, more restrictive monetary policy is not necessary and could derail an already teetering European economy.
However, the ECB cannot afford to let transitory inflation become embedded, and therefore structural. If inflation expectations stay high, higher costs will begin feeding through into wages and services inflation, creating the conditions for long-term inflation troubles. As inflation surged across 2021 and 2022, the ECB took the position that this was a ‘transitory’ phenomenon, holding rates low and allowing inflation to become embedded. If needed, policymakers will be ready to raise rates to prevent this happening again.
The ECB faces a dilemma: a trade-off between higher interest rates and economic cost. Higher borrowing costs will continue to squeeze heavily indebted households, weaken housing markets and make investment more expensive for businesses. For SMEs in particular, another increase in financing costs could mean investment plans being indefinitely postponed or abandoned altogether.
Governments across the Eurozone also face an uncomfortable trade-off. Higher interest rates increase the cost of servicing public debt, potentially reducing the fiscal room available for tax cuts, infrastructure investment and other spending priorities. Attempts to compensate households through broad fiscal support could, meanwhile, add further demand to the economy and complicate the ECB’s task of bringing inflation to a halt.
The wider concern, therefore, is not simply that inflation has passed 3%. It is that the Eurozone — and more broadly, Europe — could enter the last quarter of the year stuck between sticky inflation and increasingly restrictive monetary policy. The ECB’s top priority remains price stability, but the economic cost of achieving this may become an expensive burden that the Eurozone economy can ill-afford.
