The ECB has only one goal – price stability, which it defines as medium-term inflation close to 2 percent. In August, inflation in the euro area rose to 3.3% – the highest level in the past three years. As a result, the ECB has already raised interest rates by half a percentage point this year.
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It is probably obvious to many that higher interest rates will not solve supply problems – neither oil, gas, nor wheat prices will decrease because of this. However, the ECB is still raising interest rates, partly because it is trying to control inflation expectations. Economists disagree on how sensible this is. And history has examples where such interest rate hikes have done more harm than good.
For example, in 2011, after an oil price surge, the ECB raised base interest rates twice, the euro area economy fell into recession, and the central bank was forced to cut interest rates later that same year.
Although increased, current inflation in the euro area is very different from what we saw in 2022, when gas and electricity prices rose much more than this year, and grain prices doubled. An even more important difference is that in 2022 price growth was also driven by strong demand, which is currently absent in Europe.
Today the ECB not only raised interest rates but also updated macroeconomic forecasts. The inflation forecast for next year was raised to 2.5%, but inflation is forecasted to decrease to 2.1 percent by 2028. This forecast indicates that the ECB expects the energy price surge to be short-lived and not to spread to other goods and services. For these reasons, there is less room for further interest rate hikes.
Still, it must be acknowledged that there remains a significant risk of rising inflation. Oil, its products, and natural gas prices are still dictated by Iran’s Revolutionary Guard, which continues to heavily restrict shipping through the Strait of Hormuz with drones and missiles. As a result, natural gas in Europe is more than twice as expensive as a year ago, oil prices have again exceeded $100 per barrel, and diesel prices have approached record highs due to a lack of oil refining capacity. Another factor that could fuel inflation is food raw materials – in recent months, prices of wheat, rapeseed, corn, and other grains have started to rise faster.
Currently, markets expect the ECB to raise interest rates at least two more times by next summer, to over 3 percent. There is not much economic logic for such monetary tightening so far, so it is probably likely that the ECB will be satisfied with a more modest interest rate increase. Moreover, Swedbank forecasts that this interest rate rise will be temporary, and by 2028 rates should fall to 2 percent.
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