The European Central Bank (ECB) may not openly acknowledge it, but behind the scenes, goodwill is slipping away. Goodwill represents the intangible, invisible value of a company. When applied to a central bank, it refers to the willingness to make unpopular decisions in the short term, such as raising interest rates when inflation skyrockets. Since 2021, the ECB has squandered much of its goodwill, but during June, it has managed to regain a fraction of it.
The ECB’s governing board recently decided to further increase interest rates, and to the surprise of many, President Christine Lagarde announced that rates would rise again in July – a highly exceptional move. A pause is not even on the ECB’s radar, according to Lagarde, due to persistently high and potentially long-lasting inflation in the Eurozone. ECB economists predict inflation of 5.4% this year, followed by 3% in 2024 and over 2% in 2025. Core inflation is also expected to remain high until 2025. Although there is a decline, it is neither satisfactory nor timely, Lagarde explained.
Notably, despite accounting for a lower oil price, a stronger euro, and “significantly lower wholesale gas and electricity prices,” ECB economists have revised their inflation forecasts upwards. These factors typically exert downward pressure on inflation. Evidently, the opposing forces are strong enough to overshadow the downward pressure in the coming years. In other words, inflation in the Eurozone is proving to be remarkably persistent.
So, what is driving this strong upward pressure on Eurozone inflation? Lagarde believes that wage increases are increasingly taking the lead as a significant driver of inflation, surpassing energy prices. While energy previously played a major role in driving inflation, the rise in unit labor costs (ULC), which includes factors beyond wage increases such as productivity development and other employer costs like social security contributions, is becoming the primary source of inflationary pressures.
ULC is a broader measure of labor costs, and according to Lagarde, developments in compensation are increasingly becoming a key source of inflation. This shift is concerning for the ECB because it means that inflation is increasingly affecting the service sector and becoming more stubborn.
Given these circumstances, it is understandable that Lagarde expressed the ECB’s intention to continue raising interest rates as long as inflation persists. However, one could also argue that it is incomprehensible why the ECB did not take more significant steps, such as combining the announced rate hike in July with one in June. Given the ECB’s expectations, such a move would not only have been logical but could have also regained more goodwill.
Therefore, it would not be surprising if the ECB continues to raise rates even after July. The bank will need to persist because it procrastinated in tightening monetary policy in 2021 and 2022, while many other central banks had already taken action (and for quite some time).
Rising Rates Posing Challenges in Italy
However, it is doubtful whether these measures will be sufficient to combat inflation. Firstly, because it is likely that the ECB will not dare to go far enough, fearing the consequences. The recent outcry from the Italian government over the announced rate hike in July might be an indication that rising rates are already causing significant pain in Italy. Other Eurozone countries are likely to face similar challenges.
Secondly, an uncomfortable truth is that the ECB is trapped in a vicious cycle that must be broken to tame Eurozone inflation. What am I referring to? The ECB has been raising rates for some time now, causing economic pain. Addressing inflation after allowing it to escalate inevitably involves pain. However, Eurozone governments respond by repeatedly applying band-aids and administering antibiotics to
compensate for the pain endured by the currency union’s residents. This is evident in the (expected) budget deficits. The problem is that this compensation actually fuels inflation, thereby neutralizing the ECB’s actions and forcing the ECB to go even further. This cycle needs to stop for the Eurozone to defeat inflation. The ECB must continue raising rates, and governments must stop compensating for the pain. As difficult as it may be, it is simply impossible to defeat inflation without breaking free from this vicious circle.
Edin Mujagić, Chief Economist at OHV Vermogensbeheer and author of the Dutch book ‘Keerpunt 1971’, provides a monthly ECB Watch column for Investment Officer, focusing on the monetary policy of the European Central Bank.