Central bank chief: ECB rate hikes do have effect, inflation yet to slow

Bank of Estonia Governor Madis Müller.
Bank of Estonia Governor Madis Müller. Source: Ken Mürk/ERR

The European Central Bank (ECB) is raising three key interest rates by 25 basis points to 4.25, 4.50 and 3.75 percent, respectively, next week. This decision was expected, as inflation in the euro area is still too fast, and projected to slow only gradually, Bank of Estonia Governor Madis Müller said Friday.

In general, the slowdown in euro area inflation to 5.5 percent in June has been broadly in line with the ECB's latest forecast, Müller, a member of the Governing Council of the ECB, said according to a press release.

At the same time, the most recent news about the state of the economy in Europe has been worse than expected, and the downturn outlook seems more pessimistic than it was a few months ago. This is illustrated, among other things, by this week's news of once again declining purchasing managers' indexes (PMIs), which are considered one of the best indicators of the state of the economy in the medium term.

It is no longer feasible to refer to energy prices and other factors as the main drivers of inflation in the euro area. The prices of services and goods are rising. Behind this is an increase in growing input prices for companies, a relatively fast increase in labor costs, but also — until now — pretty good profit margins.

The sustained surge in food prices is likely to ease in the second half of the year, as the prices of several food commodities have already fallen on the world market. However, there are risks related to the difficult weather conditions for agricultural production, as well as to Russia's decision not to continue the cereal exports agreement with Ukraine. This may mean that the rise in food prices will remain rapid for even longer.

The interest rate decisions made by the ECB thus far are clearly having an effect — the interest rates of both bank loans and deposits have risen, the volume of new loans has fallen, and higher interest rates have already reduced demand in the economy. Challenges for exporters include the faltering recovery of the Chinese economy and the appreciation of the euro exchange rate since last September.

The labor market, meanwhile, remains a bright spot in the overall economic picture. The euro area is witnessing record low unemployment hand-in-hand with relatively vigorous wage growth. The same is true in Estonia, where the economy as a whole has not yet returned to a path of growth, but people's incomes are already rising faster than prices.

Generally, an overall weaker demand for goods and services tends to lead to slower price growth. The key question we are facing now is whether already high interest rates along with the poor economic outlook are sufficient for bringing inflation in the medium term to the 2 percent inflation target.

Naturally, the main goal of the ECB is to get inflation under control. Both people and companies are acutely aware of problems that result from rapid price increases. We don't want to see the type of drop in purchasing power that the people of Estonia experienced last year again.

The situation is also easing for entrepreneurs, who, until recently, had to tackle supply problems and unexpected cost increases, making it very difficult for them to plan for the future. The gradual recovery of the euro area economy will depend on how quickly inflation slows down, as well as on the recovery of the global economy and the rebound of people's purchasing power.

But what can we expect form the ECB's further decisions, and how much higher can interest rates still go?

The situation has changed since the last few Governing Council meetings. Previously, the need to increase interest rates to slow down inflation was so evident that it was possible to announce it for the following council meetings already. However, considering the current interest rate levels, decisions to increase the rates aren't so obvious anymore. Central bankers have no interest in raising interest rates higher than necessary to contain inflation. At the same time, we cannot afford to err in the other direction and risk the continuation of rapid inflation in the long term.

As a result, each of the Governing Council's next sessions will be focused on finding the right balance. Our next meeting will be in mid-September, when we'll have additional information on the state of the economy and inflation trends over the summer months. Until then, however, I don't recommend believing anyone who claims to know how high interest rates will go and when we can expect them to drop. There are just too many variables that affect the economy of the euro area.

Click here for more info about Thursday's announced interest rate hikes and the ECB's other latest monetary policy decisions.


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Editor: Aili Vahtla

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