The European Central Bank (ECB) has scheduled an October 27th meeting to raise interest rates again. After a two-time raise, the base interest rates in the eurozone are now reaching 1,25%. And may reach 2% by the end of this week. For businesses and households, it means disrupting plans that have been tied to long-held extremely low retail interest rates and negative basic interests. Raising interest rates further exacerbates the skyrocketing costs that businesses cannot pass on to the end consumer. This move may be another fatal mistake of the Eurozone’s monetary institution.
Raising interest rates is presented as an inevitable measure that may curb rampant inflation. In the eurozone, the annual inflation rate was 6 % in February (already prior to the war in Ukraine) and 10 % in September 2022. Yet, in some countries it is much higher. My native Lithuania is one of the extreme cases. There, the price growth reached 14 % in February and 24 % annual rate in September 2022. The roots of this rampage lie in the very same ECB policy: since the beginning of the pandemic, the monetary base, which represents the central bank’s contribution to the multiplication of money, has doubled. Money supply M3, which is the main trigger of inflation, picked up 25 % in Lithuania by the mid of the pandemic. In the Eurozone it peaked to nearly 13 % at the same time. This has given much room for prices to grow when the disruptions of supply chains, energy crisis, war, and other fatal factors occured. Seeing that inflation was well above expectations, ECB leaders promised to take restrictive monetary policy measures.
Theoretically, there are two such measures – raising interest rates and reducing the money supply through open market operations. The latter would directly reduce the money supply and price growth. This measure would require the ECB not to inject money back into circulation, but rather to “sterilise” it when the bonds it has acquired have matured and are redeemed. However, the ECB will not only continue its open market operations, it has also come up with a new measure under the fancy name of the “transmission protection instrument”, aptly called the bazooka by the President of the Bank of Lithuania. It is designed to combat market fragmentation, that is to say, differences in the financial sustainability of Eurozone members once they express themselves in the diverging interest rates.
The bazooka will be used to manually bomb countries in precarious financial situations, such as Greece and other Southern destinations, with money. This means that the most indebted countries non-compliant with the European Stability and Growth Pact (SGP), which enshrines the Maastricht criteria, will be supported by the increased ECB financing. Thus the ECB expects to bring down the interest rates on the Southern countries borrowing – so that Italy’s interest rates on its debts would be about the same as those of disciplined Germany.
It is clear that this new measure is not a part of a restrictive monetary policy, and is, on the contrary, an expansionary one. What does this signal to national governments? Although the Stability and Growth Pact stipulates that countries which fail to comply with the Maastricht criteria can be penalized by up to 0.2% of GDP and additional amounts of up to 0.5% of GDP, no penalties have been ever imposed. In today’s context of unprecedented inflation and “market fragmentation”, it is worth asking who has taken responsibility for the fact that countries’ debts and deficits are chronically rising and that evermore countries are failing to comply with the agreements bound to ensure the sustainability of the Euro?
For the time being, it seems that the responsibility will fall on businesses and households, who will see their loans become more expensive, even though they have kept financial discipline, and have complied with all the conditions and criteria set out in a contract. Having suffered from the expansionary monetary policy and price hikes, they will now be hit by restrictive monetary policy and higher interest rates.
When the ECB talks about “taking any measures”, one can see that the restrictive measures are primarily aimed at the private market agents. The measures will also affect financially disciplined countries, while chronically undisciplined ones will be subject to the reverse, expansionary monetary policy and lower interest rates. This implies large-scale and unprecedented redistribution.
Today, the ECB finds itself in a trap – it is impossible to keep the interest rates negative, yet increasing interest rates may completely freeze the cooling European economy, which is losing competitiveness due to the geopolitical situation and the energy crisis.
As a consolation, one may be reminded that while inflation is this high, the increased interest rates are still negative in real terms. However, negative or positive, they do not reflect the real market situation: the price of money borrowing, which may be called the fundamental price of all prices, is not determined by the market. It is governed manually by the Central Bank, which likes to, as they admit themselves, “take any measures”. The interest rate is lowered below its natural limits and encourages people to go ahead and to hurry up both in production and consumption. As people accelerate, the handbrake is suddenly put on.
Come what may, while interest rates are in the hands of a Central Bank, they are in themselves forerunners of a crisis.
Originally published at BrusselsReport.eu
