Emeritus Professor Joe Nellis is economic adviser at MHA, the accountancy and advisory firm.
When the European Central Bank raised interest rates from 0% to 0.5% in July 2022, Eurozone inflation had already reached 8.7% the month prior. Policymakers were rightly criticised for acting too slowly across 2022 and 2023, allowing inflation to climb above 10%. With inflation now sitting at 3.2%, today’s decision to raise interest rates suggests they may have learned from their mistakes.
The deposit rate has been held at 2% for the last 12 months but the ECB is demonstrating that it is now prepared to act, despite the fact that economic growth across the region remains sluggish.
Inflation across Europe is largely the result of increases in energy and transport costs, driven by ongoing tensions in the Middle East. If the conflict continues in the months ahead, we can expect interest rates to reach 3% by the end of the year.
The consequence is that consumer spending is likely to be squeezed even further, along with corporate investment spending. This could lead to growing unemployment across many sectors at a time when growth forecasts for the Eurozone are already weakening, particularly in its largest economies, Germany and France.
Interest rates remain historically low. The fact that raising them threatens to undermine economic activity in the Eurozone reveals deeper, structural problems in the economy.
On the upside, higher interest rates (relative to the rest of the world) attract foreign capital, strengthening the Euro. This helps to reduce import costs, including oil, exerting modest downward pressure on prices. Yet this benefit does little to outweigh the cost to economic growth.
The ECB has made a sensible decision by acting decisively to curb inflation. Policymakers will hope they can bring prices down quickly, allowing interest rates to follow, ensuring that tighter monetary policy does not weigh on growth for longer than necessary.
