Economy weak and inflation high: what do you do with the interest rate? 06:53 in Economy If the ECB chooses to increase interest rates, the central bank will write history. Never before have interest rates risen so quickly.

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ECB President Christine Lagarde
NOS News
  • André Meinema

    Economics reporter

  • André Meinema

    Economics reporter

Should we increase interest rates further or not? A difficult question that the European Central Bank (ECB) and central bankers of the twenty euro countries have been discussing in Frankfurt for two days.

This afternoon the ECB will announce what it will be: will the interest rate remain at 3.75 percent or will it be increased by a quarter of a percentage point to 4 percent?

If the ECB chooses to increase interest rates, the central bank will write history. A tenth interest rate increase in a row in just over a year would be unique. Never before have interest rates risen so quickly. And all this in the fight against persistent and unprecedentedly high inflation.

There are many things in favor of, but also many things against, another interest rate hike. Opinions are divided among bankers and economists and thoughts change regularly, under the guise of advancing insight.

A lot of fuss about a quarter of a percentage point, you would think, but in the world of large investments, loans, mortgages and savings interest, an interest rate increase makes a big difference.

Some parties are now calling for a new increase, but that should be the last. Other experts prefer to pause interest rates now, i.e. no increase, and if necessary, a step upward in October at the next ECB meeting, if necessary.

Interest weapon

The question is whether higher interest rates work. The interest rate weapon is intended to bring down inflation, but after nine rate increases in a row, the economy is still not where the ECB wants it to be. Inflation remains stubbornly too high. The idea that consumers and companies spend less with higher interest rates, which causes demand and therefore prices (and inflation) to fall, no longer seems to hold.

The effect and pass-through of interest rates on inflation has a relatively long braking distance, with the time between pumping the brakes and standing still easily being more than a year. It takes a while before higher interest rates reach companies and consumers. That interest rate does not reach everyone at the same time. Meanwhile, demand for loans, credits and investments is declining, both among companies and consumers.

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Interest rate decisions are subject to evolving insight and economic changes. After all, what do all these past interest rate increases lead to and what do they do to the economy and inflation?

The ECB is keeping its fingers on the pulse and is keen on the latest figures on productivity and prices. But people also try to look ahead and make estimates of the development of economic growth and inflation. But estimates are estimates based on current knowledge, not hard or established facts and are therefore subject to change.

Stand in the way of

Last week the European Commission published the summer forecasts for the economy and inflation for this year and next year. These estimates all differ from the spring estimates four months earlier. The economy will weaken further in 2023 and 2024 and inflation will stagnate, but is still too far above the ECB policy target of inflation around 2 percent. Two signals that prevent an easy interest rate choice.

The fact that inflation will fall in the coming months is the result of the comparison with last year, when inflation peaked extremely.

“I would not raise interest rates and wait a while,” says ING chief economist Carsten Brzeski. “The economic situation is deteriorating rapidly and inflation will come down rapidly in the coming months. But I have nothing to say and that is why I think the ECB will increase interest rates.”

President Klaas Knot of De Nederlandsche Bank, who is also at the table in Frankfurt, recently said in an interview with the Bloomberg news agency that things can still go either way at the ECB. “Don’t underestimate the chance of an interest rate increase, but a tenth increase is not a close race.”

Knot also warns against “too much pessimism” about the economy. According to him, there is more weakness than a recession.

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