On July 21st, the European Central Bank (ECB) announced that it is raising interest rates by 0.5 per cent, opting for an even higher hike than what was announced in June. Over the past few months, Positive Money Europe has repeatedly warned that higher interest rates are simply not the right solution to current price increases, as they will negatively affect people and jeopardise the well-being of our economies and the future of the post-pandemic green recovery. Why do we think so? In this blog, we answer a few questions about the impact that rising interest rates will have on people’s daily lives.

After decades of inflation being below central bank targets, the past months have marked a sharp turnaround, with Eurozone prices rising by a record 8.9% in July. This trend has directed the world’s eyes on central banks – the legal “guardians” of price stability. After months of hesitation, the European Central Bank (ECB) announced an interest rate hike at its last Governing Council meeting in July, joining other major central banks around the world in this policy move. This decision will have several repercussions on our lives.

Why has the ECB decided to raise interest rates? 

The ECB’s main goal is to keep prices stable, which – in central banks’ language – means maintaining the inflation level at 2% over the medium term. By increasing interest rates, the ECB is making borrowing money more expensive for people. This move is generally intended to encourage people to save money and discourage consumption, and can be useful in a context where rising prices are due to a very high demand, which far exceeds the supply.

Today’s situation is, however, different. As the ECB itself has acknowledged, the current price increases are not driven by excessive demand, but rather by supply-side shocks caused by the pandemic and further worsened by Russia’s invasion of Ukraine, which led to an even more significant bottleneck of energy and food.

In this case, interest rate hikes have thus another purpose, namely, as the ECB puts it, to “send a message” to the markets and “keep their inflation expectations in check”. In other words, the ECB wants to show its commitment to bringing inflation levels back to the 2% target, perhaps also in an attempt to protect its own credibility. Central banks believe in the power of sending this kind of messages, but this is very far from actually helping people cope with the current cost of living crisis.

Will higher interest rates slow down price increases? 

The price increases that we’ve been experiencing in the past months are driven by specific reasons, but none of them is people having too much money and spending too much. Oil and other commodities prices started to rise already in 2021, while globally, supply chains  were being put under great strain by Covid19. Then – with the escalation of the war in Ukraine, and Vladimir Putin weaponising Russia’s fossil fuels against the EU – energy prices have continued to go up even more. Currently, energy is the main factor driving inflation in the euro area, and some – including the ECB – have started to use the term “fossilflation” to emphasise how our dependence on fossil fuels is actually at the heart of the issue.

Higher interest rates cannot address supply-side constraints, let alone bring down soaring food and fossil energy prices caused by geopolitical tensions. Instead of contributing to slowing down prices, rate hikes can end up causing even more damages. 

What are the dangers of higher interest rates for people? 

When the central bank raises interest rates, commercial banks experience an increase in their refinancing costs, which they tend to pass on to borrowers. If you have a mortgage to pay, for example, you may see the cost of your installments rise. 

Besides, rate hikes penalise groups of the population who are already vulnerable: precarious workers and generally low-income households who, in the current situation, suffer most from higher prices of essential goods and services like food and energy. 

Businesses and firms will indeed tend to pass the increased costs on to consumers. They may even decide not to implement planned wage rises or, in some cases, even to fire their workers. This is especially a risk for those who are in a more precarious position, such as younger workers with short-term contracts. 

At the moment, putting people out of work is even more counterproductive for our economies and for fighting price increases: since these are partly caused by supply-side bottlenecks, if we are to overcome the crisis we need stronger employment and supply, surely not the opposite.

What are the dangers of higher interest rates for Eurozone governments?  

Interest rate hikes have also fuelled concerns about the risk of “fragmentation” in the single currency bloc – that is, a divergence in the governments’ borrowing costs. In short, what is feared is that the ECB’s rate hikes could disproportionately increase borrowing costs in countries which are viewed by financial markets as more “risky”. This exacerbates existing problems, such as little public investments, and creates new ones, such as growing unsustainability of the public debt due to the higher interest that countries will have to pay on their debt.

To mitigate these concerns, at the last Governing Council meeting the ECB also announced a new anti-fragmentation tool, the Transmission Protection Tool (TPI), under which it will buy unlimited assets in those countries that it deems to be suffering from an unjustified rise in borrowing costs. 

Does the ECB have any other options than hiking interest rates? 

The ECB definitely has other options at its disposal, but these require the Bank to think outside of its usual monetary policy toolbox. What we need right now are policies that can bring energy costs down for people, and help us move away from fossil fuels. As we have already proposed, one solution is for the ECB to initiate a lending programme to commercial banks that foresees a green discount rate, to be applied only under the condition that banks offer zero-percent loans to people to carry out projects of energy-efficient home renovation and transition to clean energy. In this way, the Central Bank’s policies – together with governments’ measures to immediately help people address the rising cost of living – would contribute to stopping fossilflation and decreasing pressure on people. The ECB has not entirely shut the door on such alternatives – on the contrary, President Lagarde has reiterated on several occasions her willingness to consider this instrument. 

Nevertheless, by simply raising interest rates now, the Central Bank is taking a route that can damage workers and discourage all investments, even those we need the most such as investments in the green transition. Clearly, this cannot be the right move. Positive Money Europe, empowered by its partners and supporters, will continue to advocate for more efficient and fair solutions to this crisis.

 

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