Emeritus Professor Joe Nellis is Head of Economic Research at MHA, the accountancy and advisory firm.
With inflation rising to 3.3% in August and Brent crude oil once again above $100 a barrel, the European Central Bank has decided that the European — and global, economy is no longer facing merely a short-term inflation shock. The Bank has raised interest rates, taking the deposit facility to 2.5%, as transitory inflation pressures have become structural.
Interest rates in the Euro Area remain comfortably below those of the UK and US, but the gap is closing as central banks look to find the ‘goldilocks solution’ for monetary policy: a level that curbs inflation without extinguishing growth, in an environment of geopolitical instability and energy supply vulnerability.
Inflation expectations are high. As businesses and their employees expect prices to rise, those expectations can become self-fulfilling: businesses raise prices and employees demand higher salaries, embedding services and wage-related inflation. While more restrictive monetary policy is not an effective response to short-term, supply-driven inflation shocks, the ECB is moving in this direction to combat inflation that is becoming more structural.
While the decision to raise rates is necessary, this is a worrying development for the European economy. The ECB faces a difficult trade-off between controlling inflation and the economic cost of higher borrowing, with further increases set to squeeze indebted households, weaken housing markets and make investment more expensive for businesses. For SMEs in particular, another rise in financing costs could see investment plans delayed or abandoned altogether.
An orderly resolution to the conflict in the Middle East would go some way towards calming inflation, but there are long-term ramifications that will endure beyond the end of hostilities. Inflation is here to stay as we head into 2027, and the ECB’s decision today shows that policymakers recognise this.
