The Governing Council of the European Central Bank (ECB) announced yet another interest rate hike on Thursday, but also indicated not to expect any more hikes in the months ahead. While they can't make any promises, their best current info suggests that inflation has slowed enough that rising incomes will boost people's purchasing power and that pressure on loan repayments is expected to ease as well, Bank of Estonian Governor Madis Müller said Friday.
"We decided yesterday at the meeting of the Governing Council of the ECB to raise interest rates by a further 0.25 percentage point, though we also indicated that based on our current assessment, no further rises in interest rates should be expected in the coming months," Müller wrote in a Bank of Estonia blog post. "Interest rates have already risen high enough that inflation in the euro area should return close to 2 percent over the next couple of years as credit growth is restrained and the momentum has cooled in the euro area economy."
This does not, of course, mean that it's inconceivable that interest rates may still have to rise in the future should inflation come down more slowly than expected, he added.
"It was expected at the start of summer that the euro area economy would start to recover in the second half of the year from the cluster crises of the spike in energy prices, high overall inflation and the war in Ukraine, but this has not happened so far," Müller acknowledged. "Demand in more distant markets for goods and services from Europe has remained weak, and people have been cautious about their own personal spending. Europeans were relatively less restrained in the summer only when spending on tourism services."
According to the central bank governor, the ECB's updated economic forecast expects the economy in the euro area to start recovering gradually from the final quarter of this year. It is expected that increasing consumption will drive the recovery, as incomes are still rising, and falling inflation is improving people's purchasing power. The state of the economy and the short-term outlook are notably better in the U.S., and so it may be assumed that demand for exports of goods and services from companies in the euro area will be revived.
"There are greater problems with the Chinese economy, and that will not benefit the euro area," he noted. "Equally, however, the poorer performance of the Chinese economy may mean that energy prices are lower, reducing the negative impact from the weakness of China as an export market."
Inflation has come down somewhat, hitting 5.3 percent in the euro area in August. Nonetheless, this remains markedly above the ECB's medium-term average inflation target of 2 percent.
"Poor performance in the economy is generally accompanied by lower inflation, and that is partly the case at present as well," Müller explained. "The interest rate decisions made by the ECB to date have clearly had an impact as well, as they have restrained growth in credit. Energy prices have risen again in recent months, however, meaning that inflation this year could prove a little higher than was expected a couple of months ago."
The ECB is forecasting inflation in the euro area to average 5.6 percent this year before falling to 3.2 percent next year, and only reach 2 percent by the end of 2025.
"That the outlook has deteriorated for inflation in the euro area coming down to the desired level of 2 percent by 2025 is another important reason why we decided yesterday to raise interest rates once more," he added.
"We should be prepared that energy prices could remain above their historical averages for a long time yet," Müller said. "This is partly because of the unavoidable large investment needed to increase the capacity of renewable energy. There is also the danger that climate change and extreme weather conditions could leave inflation for food prices higher than expected over the longer term."
Competitiveness in export markets will be an important issue for European companies in the coming years, he continued, as several of the business models used until now, such as basing production on low energy prices, may not work as well any more. Competitiveness is an even more biting worry for Estonian companies and the Estonian economy in particular, as the rise in costs for businesses in Estonia has been exceptional within Europe.
Movements in inflation, incomes and interest rates, however, tell us we have probably passed through the most acute phase, Müller noted.
"People's purchasing power has been declining for more than a year, while higher interest rates have put additional pressure on the finances of those with loans," Müller said. "We have now reached a point, though, where inflation has come down far enough that incomes continuing to rise will improve people's purchasing power."
The best information currently available is suggesting that interest rates shouldn't rise much further either, due to which pressure will ease over time for loan repayments as well.
"In this case we can expect that people will start to feel more confident about their finances," the Bank of Estonia governor concluded. "It's important to emphasize in this, though, that we in the Governing Council of the ECB will continue to assess whether interest rates need to rise further, and we certainly cannot say that they will not."
Editor: Aili Vahtla