The ECB new strategy and its impact on long term rates

The ECB is changing course. With its interest rate hike scheduled for 21 July, the ECB is putting an end to a long period of very low and stable interest rates. This will be the first increase since July 7, 2011. With the increase indicated for the September meeting, there will no longer be negative rates in the ECB’s arsenal.

This change of framework is radical even if in the short term the level of interest rates remains reduced. At the end of September, the ECB’s refi rate will be only 0.5%. Further increases will come.

The ECB’s strategy is not very different from that of other major central banks. The Federal Reserve and the Bank of England have already begun the monetary tightening. If the ECB appears less reactive, it is because wages are growing much slower than in the US or Great Britain. The risk of persistence is more limited.

Because this is the risk that central banks want to avoid at all costs. They do not want to have the same experience as in the 1970s. At the time, the oil shock had caused a higher rate of inflation and this price rise had been sustained. In Spain, the average inflation rate was 16.6% between 1973 and 1982. Over the same period, it was 11% in France, 9% in the US but only 5% in Germany.

Wherever inflation had been strong and persistent, reducing it had been costly in terms of growth. The 1982 recession was painful in the United States. It followed a very sharp rise in interest rates by the Fed. This is true everywhere where governments and central banks have decided to drastically reduce inflation.

The cost of the inflationary episode had been high. High inflation is penalizing because it carries uncertainty about future prices and because it causes marked inequalities since not all contracts are indexed in the same way. To this cost is added the lower growth resulting from the restrictive measures taken to stop inflation.

To avoid this, central banks prefer to react very quickly even if it means causing a slowdown in growth or even a recession. But the total cost of the inflationary episode is now perceived as lower than that associated with long inflation followed by recession.

In tightening its monetary policy stance, the ECB wants to limit anticipations of high and persistent inflation that could lead to higher wages, creating a wage-price spiral. Even if core inflation is not too high, the ECB has to limit this risk.

However, several questions are asked.

Central banks and the ECB will have to tighten monetary conditions but up to what level of interest rates? There is a lack of reference on this point. Economists used to reason on a formula that conditioned the central bank’s interest rate on growth and inflation. It worked well but since the financial crisis of 2008 monetary policies are heterodox. Quantitative easing is confusing and no longer allows a simple calculation.

To set the ideas, I look at the ECB’s intervention rate (refi) minus the underlying inflation. This real rate is very low given the high inflation. However, from 2015 to 2019, this rate was stable around -1%. We can consider that this is a neutral rate for the ECB. Returning to this neutral rate would put the refi rate between 2 and 3%. This is the objective we must keep in mind.

If the ECB gets tough, what about long-term interest rates? These have already risen sharply. Here too, what reference should be made to adjust the pace of long-term interest rates. The reversal of monetary policy in the US in February 1994 is a good reference. When the Fed announced its change in strategy, long-term rates rose very quickly. The profile is about the same in 2022. In 1994, after a few weeks and due to the determination of the central banks, investors were convinced that the inflationary risk would not materialize. Long-term rates remained high but stabilized. In the current episode, if central banks are credible in the fight against inflation and if they do what is necessary then investors will not include an inflation premium. Long-term interest rates could then stabilize. Looking at 1994, the 10-year rate in Germany would end the year at just over 1.5%.

The difficulty for the ECB in implementing its new monetary strategy is the spread of interest rates between the different countries in the area. The change of policy by the ECB penalizes Spain and Italy. The ECB will have to adjust its strategy to limit the risk of financial fragmentation in the Eurozone. This somewhat reduces the readability of monetary policy.

The last point is the monetary policy framework. The ECB had an inflation target of 2%. Can it keep that target as the world change? Probably not. Therefore, the ECB will have to be clear on what it wants to do to maintain its credibility, because inflation will deviate permanently from the current target.