The Governing Council of the European Central Bank has decided to leave the current interest rate level unchanged for the time being. Following a series of sharp rate increases, the central bank is taking a pause to observe the impact to date on the wider economy and financing markets. From the perspective of the German Institute for Economic Research (DIW), however, this stance carries substantial monetary policy risks.
Marcel Fratzscher, President of DIW Berlin, assesses the move as comprehensible but fraught with risk. Inflation remains significantly elevated and upside risks persist. In particular, the war in the Middle East and rising energy prices increase the likelihood that inflation will exceed previous expectations next year as well. In December, the central bank is likely to have to adjust its official inflation forecast upwards accordingly.
Relief regarding second-round effects, warning over expectations
The institute sees positive signs in the fact that no significant second-round effects have been recorded so far. Neither corporate profits nor wages have shown clear indicators of a reinforcing wage-price spiral. Furthermore, core inflation saw a markedly lower increase than headline inflation. With a time lag, however, food prices could rise once again, which would weigh especially on lower-income households.
The primary concern among economists centres on longer-term inflation expectations. At 2.5 per cent over a five-year horizon, these stand noticeably above the central bank's two per cent target. As a result, there is a risk that heightened price expectations become permanently entrenched, undermining confidence in the monetary authorities' stability policies.
Monetary policy dilemma between bond markets and credibility
According to Fratzscher, the central bank finds itself in a challenging balancing act. While financial markets are already pricing in future rate hikes, recent turbulence in the bond markets has noticeably tightened financing conditions anyway, placing an additional drag on the already fragile economic recovery.
- —Unchanged interest rate level: The ECB Governing Council temporarily pauses the cycle of interest rate hikes.
- —Geopolitical risk factors: Conflicts in the Middle East and rising energy prices weigh on forecasts for the coming year.
- —Decoupled expectations: Five-year inflation expectations remain above the two per cent target at 2.5 per cent.
- —Tightened financing conditions: Turbulence in the bond markets is already noticeably dampening the economic recovery.
According to DIW, a further rate hike would have signalled an unequivocal commitment to the uncompromising defence of price stability. The decision to wait for further data series could ultimately prove to be an omission: hesitating too long threatens to entrench inflation expectations, whereas premature action would unnecessarily weaken economic performance.
