Inflation rates and interest rates have been low across the EU for the last decade. So low, in fact, that the European Central Bank’s main concern was ensuring that they were not too low for comfort, as low inflation/rates can cause their own problems. But as interest rates soar and the annual rate of inflation across the eurozone hit 8.6% in June, the ECB has an entirely different set of problems on its hands. Handling inflation is a complex problem, and for the ECB, it is a problem they have to handle 19 times, one for each of its member states. The contrast is stark. The ECB’s policymakers meet once a year in Sintra, Portugal, to discuss how to tackle pressing macroeconomic issues. But this year, the discussions are now based on lowering, not raising rates. Although not all experts agree on how to accomplish this task, there was consensus in one regard: quick and decisive action is needed.
The reasons for the ECB’s woes are well-known: the war in Ukraine, skyrocketing energy prices, and the fact that global supply chain disruptions that started during COVID have not let up. What is not entirely known is how to avoid the worse possible outcome: stagflation. That is when there is an extended period of stagnant economic growth coupled with high inflation. To combat stagflation, the ECB plans to raise interest rates in July for the first time in more than ten years. The plan is to increase them in July by .25%, then again in September by an undisclosed number (though it is likely to be more than .25%), and then rates will continue to rise from there. This path follows the “gradualism” principle, which is meant to avoid spooking markets and setting off panics.
The Hydra
The toughest thing for the central bank is that they do not know exactly what they need to do to turn inflation down without overdoing it. They have a few methods, like changing interest rates, but those changes have delayed reactions. The ECB will not know if its changes were effective until months after its actions. Thus, their delayed-onset actions mean they have to do their best to predict the future via educated guesses. To do that, they weigh data from household, business, and financial market data, and there is much debate about assigning weights to each of those areas. Even though they do not know if their actions will be effective, they do know that they will cause pain. But high inflation itself will definitely cause more pain for everybody involved; that is why inaction is not a viable path forward.
Some have accused the ECB of waiting too long to make interest rate changes. After all, its US counterpart, the Fed, has already made interest rate changes in recent months. But the ECB points to its causes of inflation as justification for its slower movement. The Fed is trying to address an American economy that is overheating, and they are trying to cool it down. That is not the problem in Europe, where overall consumption is still less than it was before the pandemic. The ECB not only has to solve this inflation problem, but it has to solve it in a way that works for 19 semi-independent yet co-dependent economies. For example, June inflation was 6.1% in Malta but 22% in Estonia. Given the complexity of the task at hand, maybe a slow, concerted approach is not such a bad path forward.