The European Central Bank gave a record response to record inflation. On September 8, the ECB management raised the key rate in the euro area immediately by 0.75 percentage points (or 75 basis points). The European regulator has never undertaken such a sharp tightening of its monetary policy in the entire history of the single currency of the EU.
Eurozone base rate still lower than US
The day before, on September 7, the Central Bank of Canada took an equally decisive step. And before that, in June and July, the US Federal Reserve System (FRS), the American analogue of the central bank, even raised the base interest rate by the same 0.75 percentage points twice in a row, although a change of 0.25 percentage points is considered normal. P. So the ECB is not alone in its determination.
The difference is that in Canada, the key rate at which commercial banks borrow money from the central bank, in order to then issue them in the form of loans to businesses and the public at a certain premium, has already reached 3.25%. In the US, this rate, which plays a key role in regulating the money supply in circulation, is in the range of 2.25-2.5%.
And in the euro area, after the current increase, it amounted to 1.25%. Thus, the credit policy of the European Central Bank is still relatively soft, and money in Europe, respectively, is cheap.
Did the ECB sleep through inflation?
That is why one can often find in the media the assertion that a surge was overslept at the headquarters of the ECB in Frankfurt am Main euro zone inflation. It’s not that they didn’t notice how the rate of price growth reached a record 9.1% in the history of the euro currency, although 2% per annum is considered the optimal level for the healthy development of the economy. The head of the bank, Christine Lagarde, and her colleagues are reproached for underestimating inflationary dynamics and delaying too long.
However, their indecision had a very definite reason. The ECB kept its base rate close to zero for a whole decade, and since 2016 just at zero, in order to give the most indebted countries of the eurozone time and opportunity to stabilize their finances and reduce public debts. The same goal was pursued by the program of large-scale purchase of government bonds of the eurozone countries, which was officially completed in June 2022, although the bank’s management retained the opportunity to resume it in a different form.
In short, the super-cheap money (or “printing press”) policy was designed to prevent a recurrence of the acute debt crisis of the early 2010s and was carried out mainly in the interests of countries such as Greece, Spain, Portugal, and especially Italy.
The danger of a recession and a new debt crisis in the EU has increased
That’s why The ECB took the risk of raising rates only on July 21, 2022 from 0% to 0.5%, while the Fed began to rapidly tighten its monetary policy back in March. However, the further acceleration of European inflation in August left Christine Lagarde no other choice, although the representatives of Italy and Greece in the leadership of the regulator advocated, according to media reports, for a more moderate increase (whereas the representatives of Germany and the Netherlands were just in favor of a big step by 0.75 p.p.).
The now unanimous decision, as emphasized by the ECB, essentially means that the European regulator, like the central banks of other Western countries, has decided to act on the principle of “it is better to have an economic downturn than a rise in prices.” After all, raising the rate is nothing but a targeted measure to reduce business and consumer activity by increasing the cost of credit resources. A sharp increase in the rate, in turn, is often described in the media by the journalistic expression “suffocation of the economic situation.” But if GDP growth slows down or even becomes negative, then, as a rule, inflation also slows down.
Thus, after September 8, a recession in the euro area and throughout the European Union became more likely. The danger of such a recession has grown in recent months, primarily due to the extreme rise in the cost of energy, especially gas, which has increased the costs of industry and additional costs for consumers. It was the high cost of energy that also became the main reason for the surge in inflation, although by no means the only one.
Oil prices have already fallen
Since economic downturns usually lead to a decrease in demand for energy and, in general, for raw materials, tightening the ECB’s monetary policy, in theory, increases the chances of cheaper energy commodities. And the faster and stronger the fall in oil and gas prices, the sooner inflation will slow down in the eurozone. Lowering its pace, in turn, can prevent further tightening of monetary policy and thus reduce the risk of a recession.
It is striking that in the first days of September, against the backdrop of growing fears of a recession in the United States and Europe and on the eve of a sharp increase in the ECB rate expected by many market participants, the ECB noticeably accelerated the decline in world oil prices that began in June. As a result, a barrel of European grade Brent, which cost $124 at the beginning of the summer and about $105 at the end of August, fell by September 8 to about $87.5.
Thus, oil quotes, we emphasize this, have now returned to the level at which they were in January 2022, before the Russian invasion of Ukraine and before the announcement by Western countries of an oil embargo against Russia. Meanwhile, global aluminum prices have fallen to their lowest level since the beginning of 2021, and copper is now at the end of the pandemic 2020.
Why did the euro depreciate so much this year
True, immediately after the decision of the ECB, oil quotes rose slightly, and on September 9, during trading, they reached a level of about $91. One of the explanations for this not entirely textbook reaction is that the market compensates thereby for the depreciation of the dollar, which made oil cheaper for holders of other currencies, primarily the euro.
And the European currency, indeed, showed a classic reaction to the increase in the base rate: it strengthened. And thus, it reaffirmed that for the exchange rate of the two most important reserve currencies in the world – the dollar and the euro, as well as for other currency pairs, it is precisely the levels of interest rates that are of paramount importance.
There is no other way to explain why by the beginning of September not only the euro exchange rate fell against the dollar to the lowest level in 20 years, but the Japanese yen also fell to 24-year-old levels, and the British pound sterling generally returned to 1985 quotes. All of these currencies have been affected by the flow of cash into the dollar space, as strong increases in US rates have boosted yields on US government bonds and other financial instruments.
The fact that the Fed intends to resolutely raise rates to curb inflation became clear back in February. At the same time, the gradual depreciation of the euro against the dollar began, which fell from a level of about 1.14 at the beginning of the year to 1:1 parity in Julyafter which he began to fluctuate around this iconic mark.
In time, this coincided with the war in Ukraine and the sharp aggravation of the energy crisis in the European Union, and therefore it is widely believed in Russia that the main reason for the current devaluation of the European currency was the EU sanctions against the Russian Federation. War, sanctions and energy issues have undoubtedly played their part, yet the main reason for the weakening of the euro, yen and pound was the strengthening of the dollar.
Fed will continue rapid rate hikes soon
But as soon as the ECB closed the gap between the levels of rates in the eurozone and in the US, the euro exchange rate, which had fallen below 0.99 at the beginning of the week, rose to about 1.01 on Friday, September 9. However, the strengthening of the European currency is unlikely to be strong and lasting, because already on September 21, the leadership of the Fed at its regular meeting will most likely raise rates again, and it is possible that again, for the third time in a row, by 0.75 percentage points.
In this case, not only in the United States, fears will increase that high rates will stifle economic growth. The prospect of a recession will become even more real in Europe. At the same time, one can assume that the growing pessimism of businesses and consumers will help central banks on both sides of the Atlantic bring down the prices of oil and other energy products, and thus inflation. There is currently no other, less painful way for monetary policymakers to slow down its pace.