The European Central Bank (ECB) recently decided not to cut policy interest rates yet. Had it taken its mandate seriously, the ECB should have done so, however. Not only do unnecessarily high interest rates have economic consequences, but they also slow down the energy transition.
"The consensus around the table of the Governing Council was that it was premature to discuss rate cuts," said ECB President Christine Lagarde, who indicated shortly after the January policy meeting that a first rate cut was most likely in or by summer. This diverged from the much less cautious tone of US Federal Reserve Chair Jay Powell. Already in December, he indicated that the discussion on interest rate cuts had begun and advocated for lowering interest rates even before the 2% inflation target is reached. Lagarde's reticence is particularly striking in this context, given the more dire economic and geopolitical situation in the eurozone.
Outdated salary figures and a recession
Lagarde's caution seems to stem from fears that inflation in the eurozone could resurface. But she is basing that scare on the wrong indicators. The latest inflation figures already point to a decline, with eurozone inflation at 2.8% in January (compared to 3.4% in the US). Yet ECB officials continue to focus mainly on wage growth, which is a notorious lagging indicator. Of course, wage growth is still elevated, this is a natural response to the previous sharp price increases. But it is the current pace of wage growth that matters. And the figures that the ECB considers most important are only reported once a quarter. These do indeed still show an acceleration, but according to more recent estimates, wage growth has already been weakening since then.
Given that the eurozone has hardly seen any economic growth for a year, this is also no reason to be afraid of persistent inflation. The eurozone economy broadly stagnated in the second half of 2023. In addition, the outlook for 2024 is not much better, mainly because of fiscal consolidation and the lagged effects of tight monetary policy.
Different ailment, different medicine
The ECB should also remember that the root cause of high inflation in the eurozone was not the same as that in the US. Energy was the primary concern in the eurozone, as gas prices rose because of the energy dependence on Russia. In the US, inflation was much more of a domestic problem due to an overheated economy. The US is self-sufficient in terms of energy.
These different causes also require different approaches from the central banks. According to an estimate by Allianz, the Federal Reserve has so far contributed about 45% to the decrease in inflation, mainly by squeezing domestic demand and keeping inflation expectations in check. The remaining 55% decrease was due to the recovery of global supply chains after the COVID lockdowns. Because the eurozone’s inflation problem was never really caused by surging domestic demand, but mostly by the war in Ukraine, monetary tightening was less needed. And because of this difference, the influence of the ECB on eurozone inflation is also likely to be much more limited. The ECB can therefore loosen the monetary reins sooner.
In addition, the higher interest rates in the eurozone are harming the energy transition, thereby amplifying the eurozone’s geopolitical fragility. Higher interest rates mainly hinder renewable energy projects, as these tend to be capital-intensive projects with high start-up costs that take many years to become profitable.
An unnecessarily long period of high interest rates therefore runs counter to the ECB's mandate to support the EU's general economic policy. The EU wants to get rid of fossil fuels quickly, not only because of the climate but also to be less dependent on foreign powers. Higher interest rates will only prolong that dependency. And this in turn creates a persistent risk of sudden price increases, which is contrary to the ECB's mandate for price stability.
ECB must fully commit to energy transition
Based on its mandate, the ECB should therefore fully commit to a rapid energy transition. This requires lower interest rates. Every month that the ECB delays this decision, the more unnecessary harm it causes to the EU economy. And even if the ECB eventually lowers interest rates in summer, it will by then probably take quite some time for the economy to recover enough and investments to get back on track. The ECB must commit to avoid this unnecessary delay.
This is an translation of Joeri de Wilde's column on Financial Investigator, published 16 January 2024.