The rise in ECB rates in a critical key

No surprises. The Governing Council of the ECB decided by a large majority to raise the reference interest rate for the euro area by half a percentage point, to 3.5%, in accordance with its initial plan. The price of money has not been this high since late 2008.

With this decision, he sent a message of prioritizing the fight against inflation in the face of potential global banking turmoil.

Before the meeting of the Governing Council of the European monetary authority, some analysts had speculated with a rise of only 0.25 percentage points after learning about the collapse of Silicon Valley Bank (SVB), Signature Bank and the Credit Suisse crisis.

Control inflation, primary objective

However, the European economy is exposed to the SVB crisis to a limited extent, so the refusal to raise rates by half a point could have been interpreted as a lack of commitment to the primary objective of the institution, price stability in the euro area, without forgetting that financial stability is also on your list of secondary goals.

Inflation remains high in the Eurozone and is expected to remain so. The variation of the harmonized CPI between February 2022 and February 2023 was 8.5% according to Eurostat, with increases of 15-20% in the Baltic countries, 9.3% in Germany, 9.9% in Italy, 7, 2% in France and 6.5% in Spain.

In February, core inflation, which excludes the most volatile components of the CPI, fresh food and energy, reached maximums in the euro area of ​​5.6%. While energy prices seem to have moderated, services, and especially processed foods, have suffered strong increases, indicating that the rise in prices of raw materials continues to be reflected throughout the value chains.

Year-on-year inflation in the euro area according to CPI components (in %).
ECB

Employment, wages and purchasing power

Other factors that contributed to the ECB’s decision is the resilience of the economies of the European Monetary Union and the strength of its labor market. The unemployment rate stands at a low of 6.7% according to Eurostat, which could lead to wage increases and exacerbate the inflationary spiral.

However, this argument is challenged by an internal ECB report, presented during its meeting in the Finnish town of Irani: companies have raised their profit margins in the current inflationary context while consumers and employees have lost purchasing power.

Wages have grown below inflation, subtracting an average of 5% of the purchasing power of an employee compared to the 2021 level. In addition, thousands of households that had signed variable-rate mortgages now have to face increases of several hundred euros in their monthly installments. It would be an inflation dynamic different from that of the 70s of the last century, when the unions demanded wage increases proportional to inflation. However, in the ECB’s speech only the salary factor weighs and capital gains are not discussed.

Salary variation in the United States and the euro area (in %).  a) nominal wages b) real wages adjusted for inflation
Salary variation in the United States and the euro area (in %). a) nominal wages b) real wages adjusted for inflation.
Source: ECB

Transatlantic banking turmoil

On the other hand, the rapid rises in rates in less than a year by the Federal Reserve and the ECB have contributed to the crises at Silicon Valley Bank and Credit Suisse. High interest rates toughen financing conditions for financial institutions and damage the value of their existing assets and credits. As a result, analysts expect the Federal Reserve to raise interest rates at a more moderate pace at its next meeting, perhaps by 0.25 percentage points.

The banking crisis that is affecting a leading sector in the United States and the fragility of Credit Suisse, which was already dragging scandals and liquidity problems and scandals, may condition the ECB’s future plans.

The collapse of SVB may implement conservatism among financial institutions and reduce the flow of credit, something that happened in 2008 and exacerbated the global financial crisis.

Jean-Claude Trichet, who then held the same position as Lagarde today, responded with a slight rate hike in the face of inflationary forecasts even though several US banks had already failed. That was one of the big mistakes of the ECB.

This time, Lagarde will try not to stumble over the same stone and promises to offer liquidity to the banks, if necessary. He has so far avoided giving clues about future rate hikes. He will have to wait until May 4 to find out for sure.

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