Expert Comment: Why are Eurozone interest rates increasing?

Euro Area inflation has reached an all-time high. Dr Luke Buchanan-Hodgman explains the European Central Bank response and its possible consequences.

With the European Central Bank (ECB) announcing its intentions to raise interest rates for the first time in more than 11 years in an attempt to control soaring inflation in the eurozone, Dr Luke Buchanan-Hodgman explains:

‘With Euro Area inflation reaching an all-time high of 8.1% in the year to May, the European Central Bank (ECB) yesterday signalled a reversal of what is more than a decade of ultra-accommodative monetary policy. The first of what will be a sequence of rate hikes kicks off in July, when rates ratchet up by a quarter of a percentage point. But why is this happening? The story here is much the same as elsewhere: a rapid increase in the price of food and energy pushing inflation well above target. However, unlike in the US and the UK – where policy rates sit at around 1% with comparable inflation – the ECB must consider how even a moderate tightening could spill over into sovereign debt markets.

‘Concerns about the upside risk to inflation, should the ECB underplay its hand, looks very different if you are sitting in Berlin than if you are sitting in Rome. Fragmentation – a fancy term used to describe a widening of borrowing costs across Euro Area sovereign states, similar to what we saw in 2012 – is a very real danger. When policy is loose, there is generally no trade-off between the dual objectives of financial stability and price stability across the Euro Area. But as you begin to tighten, this changes. The increase in the cost of borrowing could be very different across states.

‘Although the ECB must act to ensure inflation expectations in the medium term remain anchored around target, we should not be surprised if the speed at which tightening occurs is somewhat slower than in the US or the UK. And after all, the reputational and economic damage that would be wrought, if aggressive policy resulted in financial instability, would be harder to justify than simply moving too slowly when all the world is dealing with the same problem.’

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