The ECB’s interest rate dilemma – Malcolm Bray

The main objective of a central bank is to maintain price stability. The European Central Bank (ECB) considers that price stability is better maintained by targeting an inflation target of 2% over the medium term. To this end, the Governing Council of the ECB meets regularly to set its key rates.

The latter influences the interest rates that the banks in turn offer their customers. The long period of exceptionally low official interest rates allowed banks to offer loans at more affordable rates, but also resulted in less attractive interest rates on deposits.

A high inflationary environment normally leads to an increase in official interest rates. Economic theory suggests that higher interest rates would limit overall spending in the economy, creating a chilling effect on prices.

This explains the US Federal Reserve’s decision to raise interest rates in March. On the other hand, the ECB has so far kept interest rates unchanged at historically low levels, despite the inflation rate in the Eurozone reaching historically high levels.

Monetary policy decisions impact the economy with a lag, normally exceeding one year. To solve this problem, central banks base their decisions on the future evolution of prices. Therefore, what matters is not the current inflation rate but rather the expected inflation rate.

Another factor to consider is the so-called Brainard Principle, which states that politics should be conservative in the face of uncertainty. This is all the more relevant as there is considerable uncertainty about the outlook for medium-term inflation rates in the euro area.

The ECB’s current baseline forecast predicts that inflation in the euro area will be high this year, but is then expected to stabilize around 2% in 2023 and 2024. Like any forecast, this scenario is based on technical assumptions . A key assumption is that inflation expectations remain anchored around the ECB’s 2% target.

The ECB’s baseline forecast predicts eurozone inflation will be high this year-Malcolm Bray

Expectations play a central role in economics, especially since they often turn into self-fulfilling prophecies. However, the longer inflation in the euro zone remains significantly above 2%, the less plausible this hypothesis will appear. Incoming data on inflation will therefore be a key variable that the ECB will monitor over the coming months, to check to what extent there is a risk that the high inflation environment persists.

As ECB Vice-President Luis de Guindos said in a recent interview, “our decisions are based on data. Second-round effects and a possible unanchoring of medium-term inflation expectations will be the decisive factors.

The last time the ECB raised interest rates was more than 10 years ago, in 2011. At this juncture, one cannot rule out a return to interest rate hikes by the ECB in the coming months. Indeed, according to the March 2022 ECB Survey of Currency Analysts, the median expectation of professional forecasters for a possible rate hike is December 2022.

At the same time, to address possible concerns, particularly at a time when Europe is being hit by the adverse economic effects of the war in Ukraine and the sanctions against Russia, ECB President Christine Lagarde has stated that “future rate adjustments, when they occur, will be gradual”.

Current business financing conditions in Malta remain attractive. Data released by the Central Bank of Malta shows that in January 2022 the weighted average interest rate on outstanding corporate loans in Malta was almost 300 basis points lower than when Malta adopted the euro, in January 2008.

In addition to the ECB’s accommodative monetary policy, the various risk-sharing instruments provided by the European Investment Bank, as well as the Development Bank of Malta, also allow Maltese banks to offer attractive terms on some of their loans.

These include interest rate subsidies and less onerous collateral requirements. Since these schemes normally come with a time limit and an overall envelope amount, it is in the interests of companies to explore how they can exploit these opportunities.

Malcolm Bray is a market intelligence specialist at Bank of Valletta.

The author and Bank of Valletta have obtained the information contained in this article from sources they believe to be reliable, but they have not independently verified the information contained herein and therefore its accuracy cannot be guaranteed. .

The author and the bank make no warranties, representations or guarantees and accept no responsibility for the accuracy or completeness of the information contained in this article. The author and the bank are under no obligation to update, modify, or amend the article, or to otherwise notify readers in the event that any matter referred to therein, or any opinion, projection , forecast or estimate made herein subsequently changes or becomes inaccurate.

Bank of Valletta plc is a limited company regulated by the MFSA and is authorized to carry on banking business in accordance with the Banking Act (Cap. 371 of the Laws of Malta).

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