Central bank governor: Time of negative Eurozone interest rates over

Bank of Estonia (Eesti Pank) director Madis Müller.
Bank of Estonia (Eesti Pank) director Madis Müller. Source: Siim Lõvi /ERR

Overly rapid price advance is like a devious tax that hinders the normal functioning of the economy and that no voter or politician has supported. This is something all policymakers should keep in mind, Governor of the Bank of Estonia Madis Müller writes.

Because the price advance outlook has clearly worsened since early June, it was decided at the recent European Central Bank Council meeting to hike the central bank's interest rates by 0.5 points. The aim of the step is to limit Eurozone price advance to around 2 percent in the next few years.

This shift in policy started earlier when we stopped quantitative easing or printing money as it is popularly known. In connection with this, loan market interest rates have been climbing since the start of the year. The interest rate that matters for Estonian borrowers – the six months' Euribor – has reached 0.6 percent. The rate remained negative for years and was lower than -0,5 percent as recently as New Years' Eve. Negative central bank interest rates have now become history, an important step toward so-called normalization of Eurozone monetary policy.

The other important decision was to approve a new monetary policy tool in the Transmission Protection Instrument (TPI) that helps ensure ECB decisions concerning loan conditions are transferred equally to all Eurozone economies.

It gives the central bank an additional lever to intervene on bond markets in a situation where investors, irrespective of the country's economic outlook, panic without reason and interest rates skyrocket as a result.

The measure is a welcome addition to the central bank's toolbox. It helps ensure monetary policy works the same for all 19 Eurozone members and the ECB hits its target of limiting average price advance to around 2 percent in the next few years.

June average Eurozone inflation of 8.6 percent was once again faster than anticipated. As is the case in Estonia, energy counts for half the Eurozone price advance. Even though the price of oil has fallen lately, the highly unstable price of gas in Europe spiked again starting in mid-June. Price advance of things other than energy and food are increasingly contributing to inflation.

It is important to understand two things when trying to make sense of the central bank's decisions. Firstly, it is very difficult for the central bank to slow down rapid price advance due to serious services or goods disruptions. This category fits the price of gas ballooning because of geopolitical reasons and price hikes caused by supply chain issues.

Secondly, the central bank cannot use higher interest rates to quickly deal with inflation, at least not without causing a deep recession in the process. At the same time, it is important to react to the altered economic situation quickly enough and adjust policy in a timely manner in case of lasting pressure on prices. That is what we have been doing in the ECB Council over the last six months, first by ending quantitative easing and secondly by hiking interest rates.

The central bank's next steps depend on new data and forecasts. We realize that these decisions, as they result in loan money becoming more expensive, will lead to slower economic growth, fewer jobs and possibly job loss, while the consequences of persistently rapid price advance would be even worse.

It is important to realize that interest rates remain favorable in historical comparison even after the central bank's recent decisions, especially looking at so-called real interest rates adjusted for inflation.

Overly rapid price advance is like a devious tax that hinders the normal functioning of the economy and that no voter or politician has supported. Whereas it is usually a regressive tax paid by relatively less wealthy people as they suffer the most as a result of higher prices.

This is something all Estonian policymakers should realize, especially since the new government has said it will not be hiking taxes.

The central bank is doing its part in slowing down inflation, while [Estonia's] fiscal policy needs to be in step to contain what is the fastest inflation in the Eurozone. It is clear that we need to support the most vulnerable groups in society in paying for energy, while the government should refrain from adding to inflation through excessive state spending and in doing so accidentally laying down an additional "inflation tax."


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Editor: Marcus Turovski

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