Müller: Interest rate hikes must prove their effects before next step taken

European Central Bank President Christine Lagarde visited Estonia on Friday. November 4, 2022.
European Central Bank President Christine Lagarde visited Estonia on Friday. November 4, 2022. Source: Ken Mürk/ERR

The European Central Bank (ECB) must continue to hike interest rates despite the falling rate of inflation across the eurozone, since that rate is still too high, Bank of Estonia (Eesti Pank) chief Madis Müller says.

According to Müller, it is hard to say for exactly how long, or to what extent, interest rates need to be raised. "In other words, this depends on how the economy actually fares in the following months and the following quarters, and how soon inflation cools," Müller told ERR Friday.

"Certainly all the ECB's board members have taken on board that it will take some time until inflation slows, while we cannot keep raising interest rates until a 2 percent inflation rate is reached, since all decisions and their ensuing economic impact come with a lag time, which is what we must take into account."

For this reason, too, interest rates were raised by 0.25 percentage points this time, compared with 0.5 percentage points last time around. "The hike in interest rates has already been quite rapid, but right now it would be prudent to give a little more time for the previous decisions to make their impact on the economy and to demonstrate their effects," Müller added.

Until now, this slowdown in inflation has primarily been caused by a fall in energy prices which, according to Müller, is also the main reason the ECB is keeping its eye on other inflation indicators, including core inflation, whose compilation ignores the most volatile energy and food price fluctuations.

"The expectation is that, going forward, core inflation might also begin to slow down, hand-in-hand with the general rise in prices, while this in turn could be a sign of more permanent weakening of inflationary pressures," he went on.

Müller said it is not viable to state exactly how long it will take for the effect of the latest interest rate hike to make itself known in the economy and subsequently in inflation figures. 

He said: "Estimates have been that maybe a year or two from now will be that time when the impact of interest rates, via the fall in credit demand, a lower level of investment and a general falling demand will actually be reflected in lower inflation rates.

The U.S. Federal Reserve has also raised interest rates by 0.25 percentage points this week, signaling that time may be up for further rate hikes.

Müller said the approach of the two central banks is similar in general, while the inflation stats have moved ahead one step. The Federal Reserve has raised interest rates higher than the ECB has, meaning it may consider an earlier pause in the process, müller said. 

"We have even lower interest rates, and as a result there is even more wiggle room."

ECB interest rate rises fall hand-in-hand with increases in the Euribor interbank interest rate. This in turn is connected to many home loans and leasing agreements concluded in Estonia. 

Müller said the requirements established by the Bank of Estonia which lenders use in assessing a borrower's ability to pay have proved well justified, with hindsight, and the domestic central bank is thus currently not planning to revise the rules.

Markets reportedly expect that the ECB might raise interest rates by another 1.5 percentage points, which would mean that the six-month Euribor base rate, currently at 3.6 percent, would rise to close to, or slightly above, 4 percent.

Müller, said speaking in the light of the perspective of a few years, it can be assumed that if inflation does get tamed, interest rates may reach a lower level once again, within that sort of time-frame, ie. a few years.

As there are 20 countries in the Eurozone, the economic situation can vary quite widely from one member state to another. 

Müller said, however, that: "All decision-makers understand that the basis must be what makes the most sense in view of the overall picture of the eurozone, and based on this, we hold these discussions," he said.

The ECB's board on Thursday opted to hike the three base interest rates by 0.25 percentage points. As a result of this decision, the interest rate for the main refinancing operations will stand at 3.75 percent from May 10; the interest rate for fixed borrowing option will be 4 percent, and the interest rate for the fixed deposit option will stand at 3.25 percent, also from May 10.


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Editor: Andrew Whyte

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