In her speech at the Jackson Hole symposium, Isabel Schnabel, an influential member of the ECB’s Executive Board, stated the need to raise interest rates quickly even in the face of the looming recession. Three factors support this strategy:
- Uncertainty about the persistence of inflation;
- threats to central bank credibility;
- potential costs of acting too late.
Markets raised the probability of a 0.75% interest rate increase at the 8 September ECB meeting to over 60%. Rates are expected to peak at 2.5%, about 1.25 percentage points higher than in July and the interest rate expected at the end of 2024 rose to 2% from 1.25% a month ago.
Schnabel’s remarks suggest the eurozone inflation outlook has worsened considerably of late. However, the data are less clear cut with several elements improving recently.
The main negative factor for eurozone inflation is the increase in natural gas prices and, because of that, electricity prices as a result of the war in Ukraine and sanctions imposed on Russia. Producer price inflation surged to 38% year-on-year in July and will rise further in August when the natural gas price set a new record. Inevitably, high producer prices fed into CPI inflation.
However, according to the PMI survey, price pressures are moderating. In August, prices paid by eurozone firms for production inputs and prices charged to customers fell for a fifth and fourth consecutive month, respectively.
European households also do not seem worried about inflation. According to the EU Commission survey, households’ inflation expectations for the next twelve months are consistent with core inflation below 2% year-on-year. The decline in households’ expectations suggests that high inflation is seen as transitory. While it is unsurprising for workers to ask for compensation for the past inflationary shock, overall wage awards should remain close to the 3% year-onyear increase that, according to ECB estimates, is consistent with the 2% inflation objective.
Furthermore, financial markets anticipate that inflation will return below the 2% objective. The inflation swap rate for the three-year period starting in two years, when the ECB expected tightening will have taken full effect, is under 2%. Subtracting the risk premium, expected inflation is less than 2%. While this may show confidence in the ECB, it may also reflect concerns about an overly aggressive policy tightening.
Finally, Schnabel anticipates that raising rates “forcefully” will stabilise the currency. Markets are not convinced and pushed the euro below parity against the US dollar despite increased rate expectations over the next twelve months. Perhaps, markets are worried that aggressive policy tightening will undermine public debt sustainability in some eurozone countries.