ECB raises interest rates, but who benefits?

This week Increased the ECB raised its policy rate by 75 basis points, the largest rate hike ever in the history of the currency union. With this interest rate jump, the central bank is trying to get inflation of more than 9% in the eurozone back under control. At the same time, the central bank also raised interest rates on balances that banks hold with the central bank and for repo transactions with banks by 75 basis points. The central bank continues to fully reinvest the proceeds of its bond portfolio. What are the consequences of this rate hike? And will the ECB get inflation back under control?

More than 40 central banks worldwide have already taken a 75 basis point rate hike. When the U.S. central bank also raised interest rates this spring, there was more pressure on the ECB to follow suit. But that turned out to be not so easy, because when the market picked up on the first suggestion of a rate hike, interest rates on Italian government bonds immediately started to rise. The central bank came up with a new support programme and decided to reinvest more of the proceeds of bonds within the existing purchase programme in debt securities of the southern euro countries. For example, the central bank tries to keep interest rate differentials between euro countries under control, but the market Doubts whether that will work.

Why is the ECB raising interest rates?

Raising interest rates makes it less attractive to borrow money, while it becomes more attractive to hold assets in euros. The idea behind the interest rate hike is that economic growth will slow down and that inflationary pressures will also decrease. In theory, higher interest rates make it less attractive to consume and invest, while saving becomes more attractive. And that means that demand for goods and services is decreasing, reducing upward price pressures. It sounds like a logical approach, but it remains to be seen whether it will work.

The ECB's strategy can be effective if high inflation is demand-driven. In other words, when the prices of goods and services have been driven up by strong demand. And that was also the case during the corona crisis, when the consumption behaviour of households changed and the demand for certain products increased sharply. When the lockdown restrictions disappeared, the demand for services such as hospitality and holidays also increased, resulting in higher prices. The economy was running at full speed, many materials and products were in short supply and the rates for container transport by sea skyrocketed.

Can the ECB fight inflation?

That all changed with the war in Ukraine. The supply of energy decreased, causing prices to skyrocket. Instead of demand-driven inflation, there is now supply-driven inflation, a phenomenon over which the central bank has even less control. The ECB cannot solve the current energy crisis with an interest rate hike, because the cause of high energy prices lies with politicians and not with the central bank. The risk is that the ECB will use this interest rate policy to slow down economic growth even further, just at a time when the economy is already cooling down and a recession is hanging over the market. One could even argue that the current situation calls for lower interest rates, so that it becomes more attractive to invest in, for example, the energy market.

For consumers and businesses, higher interest rates mean that it becomes more expensive to borrow money. Savings rates may rise again slightly, but with inflation averaging more than 9% in the eurozone, that's a pittance. By raising interest rates, the euro can strengthen slightly in value against other currencies, so that we import less inflation. But that effect is marginal compared to the unprecedented rise in energy prices. We are therefore mainly noticing the disadvantages of the interest rate policy, while it is uncertain whether the benefit of lower inflation will be realised.

Who benefits from this monetary policy?

Banks and governments benefit the most from the ECB's monetary policy. Commenting on the interest rate decision, Lagarde announced that the central bank will continue to reinvest redeemed government bonds for the time being. All principal payments on government bonds purchased under the PEPP programme are 'flexibly' reinvested in new bonds. As we mentioned earlier, Wrote In practice, this means that the central bank will reinvest repayments on German and Dutch government bonds in debt securities from southern countries such as Italy, Spain and Greece. This policy pushes interest rates down further and makes it cheaper to borrow, especially for the southern euro countries.

Banks are also benefiting from the ECB's interest rate hike. In recent years, they have been able to borrow from the central bank on very favorable terms under the TLTRO program. By investing this money in government bonds or simply parking it back at the central bank, banks were able to achieve a margin of half a percentage point of interest without risk. It already provided European banks with hundreds of millions in risk-free returns last year. And those profits will be even bigger if the central bank raises interest rates further and starts paying more interest to banks. With its monetary policy, the central bank mainly helps banks and governments of the southern countries.

This contribution was made from Geotrendlines