Is the ECB doing the right thing by raising interest rates?

On Thursday, there will be another press conference on the policy rate of the European Central Bank (ECB). Although it was assumed for a long time that interest rates will be raised again, doubts arose last week about the upcoming decision. The ECB has been raising interest rates for more than a year now, and that policy seems to be paying off as inflation eases sharply. But is it wise for the ECB to raise interest rates even further now that the economy is already starting to cool down?

Inflation

In August, inflation for the Netherlands was three percent, well below the 17.1 percent which one could read in the newspapers last September. As a result, inflation now seems to be slowly moving towards a satisfactory level, but there is a caveat to be made about the current figure. For example, economist Han de Jong arrived at an inflation rate of 8.1 percent. This is quite different from the three percent inflation rate of the CBS.

The difference lies in the way CBS measures inflation. CBS recently switched to a New calculation method, changing the role of energy contracts. Whereas previously the prices of new contracts were used, the new method also looks at current contracts. Many households initially notice even less of more expensive energy, as the price is fixed in a contract. That is why the new method better captures the price increase that households will actually have to deal with.

 The difference between the two methods. (Source: Rabobank, The)

Because of the difference between the two methods, inflation would be far too high if the old method were used for last year and the new method for this year. The official inflation figure currently published indicates the extent to which the price level based on the new method is higher or lower than the price level a year earlier under the old method. It is therefore too simplistic to wax lyrical about the three percent inflation rate in August recorded by Statistics Netherlands (CBS). The 8.1 percent inflation rate calculated by Han de Jong paints a different picture of the price increase. In that case, another interest rate hike would be wise to cope with actual inflation.

Nevertheless, we do see that inflation is falling. We also wrote earlier about the Base Effects. This means that inflation, the difference between the price level now and a year ago, could fall in the coming months. The largest price increase occurred in the summer of 2022. Prices have risen less rapidly in recent months. Inflation is therefore likely to be lower if more than a year has passed since the period in which prices rose the most. In July, Han de Jong even predicted inflation figures of around 0 percent in October.

Effect of interest rate hike

The effect of the interest rate hikes is also noticeable. So it wrote CBS last Friday that production in the Netherlands also fell in July. The production level in July 2023 was 8.3 percent lower than in July 2022. Companies are tightening their belts and living on their stocks more often, which reduces production. In addition, more and more companies are finding themselves in dire straits. For example, the number of bankruptcies is increasing as companies face higher costs. Also, the companies that received tax deferrals during the corona crisis must now start repaying that support, according to the Financieel Dagblad.

 The number of bankruptcies, which is now increasing because the economy is cooling. (Source: Rabobank, The)

Economists of the Rabobank, The expect the Dutch economy to muddle through in the near future. The staff shortage in particular will block growth in the coming years. However, there is still no question of a severe recession, as unemployment is very low at 3.6% from a historical perspective and is likely to remain low. Although the economy has now contracted for two quarters, there were 122 vacancies for every 100 unemployed people. So the labour market is still tight.

The European Commission is also less positive about economic developments and has adjusted its growth forecast for the eurozone. Economic growth in the Netherlands will remain at 0.5 percent this year and will probably not exceed this next year. 1 percent growth. The committee also cites staff shortages as the reason for the disappointing growth, as well as lower exports. If interest rates rise even further, growth could be even lower.

Germany

Lately, the German industry has also been in the news several times. Several economists have recently expressed their concerns about the industry of our eastern neighbors. The figures on the sector have been a cause for gloom for some time now. Compared to 2021, i.e. before prices started to rise, the production of energy-intensive industry fell by twenty percent. In addition, the other important sector, the automotive industry, is also struggling at the moment due to competition from China. According to Han de Jong, this is why a disaster is taking place in our neighboring country.

Production in Germany is declining sharply, especially in energy-intensive industry. (Source: Rabobank, The)

Rabobank concurs with this. According to an article of the bank, the German economy is not what it once was. While Germany benefited from cheap labor and energy for years, both components have risen significantly in price. And on top of that, there is increasing competition from China. The question is whether Germany can match China in the field of electric cars. Rabobank also wrote that the Netherlands is less dependent on Germany than before. Although Germany is still our largest trading partner, we now export relatively more to Eastern Europe and Asia.

Interest rate decision

The ECB is in a difficult situation. On the one hand, it must adhere to its primary objective; maintaining price stability. And with the inflation that households are still struggling with, an interest rate hike seems a logical step. Inflation is still too high in other countries as well. For example, inflation in the eurozone in August was 5.3 percent, still well above the policy target of 2 percent. Core inflation, i.e. the price increase excluding highly fluctuating products such as food and energy, is also still persistent. Core inflation in the Netherlands, for example, barely fell and the figure for August stands at 5.7 percent, compared to 5.8 percent a month earlier.

For the Netherlands, an interest rate hike would also help against the overheating of the economy. The economy in the Netherlands is still overcrowded. According to Rabobank, two percent more is now being produced than the maximum we can actually produce. This may be the case temporarily if employees work overtime or if maintenance on machinery is postponed, but this leads to further price increases in the long run.

On the other hand, the ECB must also be careful not to raise interest rates for too long, so we may notice the negative effects for longer than necessary. Raising interest rates will squeeze the economy. And since the effects are felt with a delay, the ECB could now exacerbate the recession with its interest rate hike. Previous periods of interest rate hikes were also accompanied by a sharp correction in stock markets. A further interest rate hike may also further complicate the situation in Germany. And that at a time when German industry has to pull out all the stops. 

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On behalf of Holland Gold, Paul Buitink and Joris Beemsterboer interview various economists and experts in the field of macroeconomics. The aim of the podcast is to provide the viewer with a better picture and guidance in an increasingly rapidly changing macroeconomic and monetary landscape. Click here  to subscribe.