ZEW Economist Friedrich Heinemann on ECB Interest Rate Decision

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14.09.2023

A Signal to Wage Policy (September 2023)

Picture of the ZEW economist Friedrich Heinemann. — Professor Friedrich Heinemann, head of the ZEW Research Department “Corporate Taxation and Public Finance” at ZEW, comments on the ECB’s interest rate decision and the european economy.

The ECB Governing Council has decided on another interest rate hike of 25 basis points. This brings the interest rate for main refinancing operations of the banks to 4.5 per cent. Friedrich Heinemann, head of the Research Unit “Corporate Taxation and Public Finance” at ZEW Mannheim and professor at Heidelberg University, has commented on this matter:

“The persistently high core inflation and the excessively sharp rise in service prices have once again given the advocates of another interest rate hike the upper hand in the ECB Governing Council. This determination in combating inflation is primarily a signal to wage policy: collective bargaining should be able to rely on the return to price stability by no later than 2025, and wages should not require adjustments for future inflation. The ECB is engaging in expectation management with its decisions, and today’s signal is significant and valuable.”

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Previous Comments

“ECB Needs More Support from Fiscal Policy” (May 2023)

The ECB Governing Council has announced the seventh interest rate hike since last summer. While previous hikes were 75 and 50 basis points, this time key interest rates increased by only 25 basis points. As a result, the interest rate for banks’ main refinancing operations is now at 3.75 per cent. Professor Friedrich Heinemann, head of the Research Unit “Corporate Taxation and Public Finance” at ZEW Mannheim, shared his views on this development:

“Inflation has proven to be persistent, and today’s small interest rate hike is unlikely to be the end of the current cycle. The ECB’s fiscal policy does not make its task any easier. The EU’s debt-financed spending programmes, as well as the federal and state governments in Germany with their new multi-billion shadow budgets all contribute to persistent inflationary pressures. In addition, the European Commission’s further loosening of debt rules is no good news for monetary policy. The ECB needs more support from fiscal policy to fulfil its commitment to maintaining stability in the foreseeable future.”

“The Alleged Dilemma Does Not Exist if the ECB Takes Its Mandate Seriously” (April 2022)

The ECB Governing Council has still not specified a date for a first interest rate hike. Despite record inflation in the eurozone, the deposit facility rate remains negative. Professor Friedrich Heinemann, head of the Research Department “Corporate Taxation and Public Finance” at ZEW Mannheim, has commented on this matter:

“The ECB claims to be in a dilemma because it is simultaneously confronted with high inflation and the threat of a war-related recession. In this situation the members of the ECB Governing Council are advised to simply take a look at the European treaties. There they will find a clear answer as to how the ECB should behave in such a situation: Since price stability is the primary objective, other objectives must be subordinated to it. The alleged dilemma does not exist if the ECB takes its mandate seriously. With every month of hesitating, the ECB Governing Council is damaging the reputation of this important European institution. A series of massively wrong inflation forecasts by ECB economists also feeds the suspicion that the assessment of inflation dynamics is driven by the desire to maintain a low interest rate policy and not, conversely, that interest rate policy is based on an undistorted inflation forecast.”

“The War Will Have a Longer-Term Inflationary Effect” (March 2022)

The ECB Governing Council has held out the prospect of putting an end to bond purchases in September if forecasts do not point to a slowdown in inflation. The end of the purchases is seen as a prerequisite for a first subsequent interest rate hike. Professor Friedrich Heinemann, head of the Research Department “Corporate Taxation and Public Finance” at ZEW Mannheim, has commented on this matter:

“The war in Ukraine has massively raised uncertainty about the economic development of the eurozone. Two weeks after the outbreak of war, it is impossible to predict to what extent the conflict will dampen the recovery of the economy. It is understandable that the ECB is still taking some time before initiating the change in monetary policy. However, the Russian invasion of Ukraine has ultimately made the necessary change all the more pressing. The renewed rise in energy prices will further fuel inflation in the short term. Even more important for monetary policy are the inflation processes that have been triggered. The accelerated restructuring of the energy supply will be costly and drive prices up for years to come. Moreover, in the forthcoming bargaining rounds, unlike last year, the unions can no longer afford to simply ignore the currently witnessed very sharp decline in the purchasing power of wages. The war will have a longer-term inflationary effect, and the Governing Council must soon find a convincing solution to this threat.”

“ECB Risks Damaging Its Reputation” (January 2022)

The ECB Governing Council has not yet initiated any measures to tighten its monetary policy in January 2022 despite the persistently high inflation in the eurozone. Professor Friedrich Heinemann, head of the research area "Corporate Taxation and Public Finance" at ZEW Mannheim, has commented on this matter:

“The ECB’s interest rate policy and bond purchases now appear to be very much out of date. Europe’s central bank is still pursuing a policy of fighting deflation, even though Europe is experiencing the strongest surge in inflation since the introduction of the euro and inflation expectations are rising. The Governing Council now risks seriously damaging the ECB’s reputation. More and more monetary policy observers are wondering whether price stability is still the ECB’s top priority. With the rigid adherence to an extremely loose policy despite this surprisingly prolonged high inflation, the suspicion is growing that a majority of the ECB’s Governing Council is driven by entirely different goals, such as the easy financing of high government deficits. It is high time that the ECB proves that it is not trapped in fiscal dominance.”

“A Half-Hearted Decision” (December 2021)

The ECB Governing Council has decided to end net bond purchases under the PEPP crisis programme at the end of March. In return, however, purchases under the regular bond-buying programme are to be expanded. Furthermore, maturing bonds will be purchased under the PEPP until at least 2024. Thus, the ECB retains a high degree of flexibility to deviate from its capital key. Professor Friedrich Heinemann, head of the research area "Corporate Taxation and Public Finance" at ZEW Mannheim, has commented on this topic:

“Although this is a first step towards exiting the crisis policy mode, the decision is still a half-hearted one. With the phase-out of the PEPP, the crisis policy mode actually ends only on paper; in fact, net government bond purchases under the PSPP continue. It is also controversial that the ECB Governing Council plans to use maturing PEPP funds until at least 2024 to provide targeted additional support to individual countries, if necessary. If the ECB does indeed continue to disproportionally benefit certain euro states for years to come with its government bond purchases, then this is no longer a conventional monetary policy, but clearly serves to finance states with critical debt levels. Such an approach, which was still justifiable in the acute crisis, is now becoming increasingly problematic as the economy recovers and inflationary pressure rises. The next proceedings before the Federal Constitutional Court and the European Court of Justice on the legitimacy of bond purchases promise to be exciting.”

“A Typical Conflict of Interests” (March 2023)

Despite the stock market turbulence following the collapse of Silicon Valley Bank (SVB) and the acute difficulties of Credit Suisse, the ECB Governing Council has decided to raise interest rates again. As announced, the sixth rate hike since July last year is again 50 basis points. As a result, the interest rate for banks' main refinancing operations is now at 3.5 percent. Professor Friedrich Heinemann, Head of the Research Unit “Corporate Taxation and Public Finance” at ZEW Mannheim, comments:

"The Fed and ECB have always had to reckon with the fact that consistent interest rate hikes could have negative side effects for the financial markets. However, central banks must not overlook the fact that entrenching inflation also entails quite considerable stability risks. In this respect, there is a classic conflict of objectives: a determined fight against inflation cannot be obtained at zero cost. This is precisely what critics of the zero interest rate policy have always warned against. The turbulence surrounding SVB and Credit Suisse now clearly shows the stress that interest rate hikes are putting on the banking sector. If there is a full-scale banking crisis, the ECB will also have to abandon its course of interest rate hikes. Nevertheless, it is right that the ECB made another big interest rate move today. Anything else would have been a sign of panic and would have added to the uncertainty."

“ECB Governing Council in the Dark About When to Expect Core Inflation to Fall” (February 2023)

The ECB Governing Council has decided to raise its key interest rates again. This is the fifth rate hike since July 2022. As expected, rates were increased by 50 basis points. The interest rate on the main refinancing operations of banks is now at 3.0 per cent. Professor Friedrich Heinemann, head of the Research Unit “Corporate Taxation and Public Finance” at ZEW Mannheim, has commented on this matter:

“The expected decline in the euro inflation rate in the coming months is the result of no longer rising energy prices and government aid. However, broad inflation dynamics measured by core inflation remain well above the ECB’s inflation target. The Governing Council is currently in the dark as to when a significant decline in core inflation can be expected. Over the past two years, the Council has had to learn how difficult it is to make inflation forecasts for more than a year ahead. Therefore, it is only reasonable that the majority of the ECB Council members want to wait for a significant decline in core inflation before ending interest rate hikes. Only the representatives of Italy and Greece in the ECB Governing Council have spoken out in recent weeks in favour of a wait-and-see approach to interest rates. The fact that it is once again the representatives of highly indebted countries who are advocating this position does not help the ECB to improve its monetary policy reputation. These finance ministers, interested in favourable financing conditions, are obviously trying to get the ECB Governing Council to support their interests.”

“2.5 Per Cent Are Still Below the Neutral Interest Rate Level” (December 2022)

The ECB Governing Council has decided to raise its key interest rates again. After its recent significant rate hike of 75 basis points in late October, the Council has now decided on a further increase of 50 basis points. The interest rate on the main refinancing operations of banks is now at 2.5 per cent. Professor Friedrich Heinemann, head of the Research Unit “Corporate Taxation and Public Finance” at ZEW Mannheim, has commented on this matter:

“Despite concerns about the economy, the latest interest rate hike should not be the final step. The real interest rate, the difference between interest rates and the expected inflation over the next two years, continues to be clearly in the negative. As a result, the current level of 2.5 per cent rate is still lower than the neutral interest rate level. Considering the still inflated central bank balance sheet, the ECB’s monetary policy continues to be expansionary. What really matters is that the ECB Governing Council is now regaining lost credibility by further tightening its policy. Barring a sudden economic slump, the ECB must not hesitate to raise interest rates and start reducing its balance sheet in early 2023.”

“Meloni’s Criticism Must Make the ECB Even More Determined” (October 2022)

The ECB Governing Council has decided on a major interest rate hike again and raised the key interest rate by 75 basis points. The interest rate on the main refinancing operations of banks is now at 2.0 per cent. Professor Friedrich Heinemann, head of the Research Unit “Corporate Taxation and Public Finance” at ZEW Mannheim, has commented on this matter:

“This second major interest rate hike was inevitable. Unlike the Fed, the ECB failed to turn its interest rate policy around in time. In view of record inflation, the ECB must now move away from its inappropriately low key interest rates as quickly as possible. This course of action is also supported by the members of the ECB Governing Council who were previously considered doves. But the most controversial debates are probably still ahead of the Council next year. High inflation and, in particular, increased inflation expectations call for higher interest rates, which could reach the four per cent mark in the course of 2023. Handling the energy recession and concerns about the debt sustainability of southern European states require a more cautious approach. In her first government statement, Italy’s new Prime Minister Giorgia Meloni called the ECB’s interest rate hikes ‘a rash choice’. Her criticism will most likely have exactly the opposite effect of what she had in mind. If the political pressure to pursue a permanently loose monetary policy becomes this evident in times of high inflation, this must make the ECB even more determined in its fight against inflation.”

“The ECB Must Curb Inflation Expectations” (July 2022)

Due to high inflation in the eurozone, the ECB Governing Council decided on an interest-rate hike of 50 basis points. In addition, the ECB introduced a “transmission protection instrument”. Professor Friedrich Heinemann, head of the Research Unit “Corporate Taxation and Public Finance” at ZEW Mannheim, has commented on this matter:

“It is a good thing that the ECB Governing Council has finally decided on a dramatic interest rate hike. The inflation rate is not expected to return to its target range any time soon. Moreover, the extremely high consumer price inflation is gradually leading to wage inflation, which will further accelerate the wage-price spiral. Under these circumstances, the ECB Governing Council finally had to show its determination to curb inflation expectations. While the interest rate decision is a step in the right direction, the new transmission protection instrument carries some potential dangers. The ECB is increasingly turning into an authority with the power to decide on the financiability of high sovereign debt and thus also on the fate of governments. This is not compatible with the monetary policy task of an independent central bank.”

“The End of Asset Purchases Comes at Least Three Months Too Late” (June 2022)

The ECB Governing Council has decided to end asset purchases at the end of June, clearing the way for a first interest rate hike in July. Professor Friedrich Heinemann, head of the Research Department “Corporate Taxation and Public Finance” at ZEW Mannheim, has commented on this matter:

“The end of the asset purchases was overdue and comes at least three months too late. Looking back at monetary policy in recent years, a strong asymmetry becomes apparent. If inflation was too low, the ECB always acted quickly using all available means to fight it. By contrast, Europe’s central bank has been very slow to counteract the currently far too high inflation. One explanation for the ECB’s eagerness to act when price increases are low and its passivity when inflation is too high can be found in the euro government bond market: The prospect of a cautious turnaround in monetary policy already pushed the Italy’s bond spread back up to over 200 basis points. The fear of a new euro debt crisis is still paralysing the ECB and damaging its credibility. The fact that the eurozone has not yet found a credible strategy for dealing with heavily indebted states is now taking its toll.”

“The ECB Is Currently Doing a Convincing Job” (June 2023)

The ECB Governing Council has decided on another interest rate hike of 25 basis points. This brings the interest rate for main refinancing operations of the banks to 4.0 per cent. Professor Friedrich Heinemann, head of the Research Unit “Corporate Taxation and Public Finance” at ZEW Mannheim, has commented on this matter:

“The ECB is currently doing a convincing job in regaining lost trust. Despite an unfavourable economic outlook, it continues to raise interest rates, demonstrating that the restoration of price stability is a priority. However, some favourable developments in recent months have made this course of action possible. The current Italian government is pursuing a comparatively cautious fiscal policy, preventing Italian government bond yields from spiralling out of control amidst rising ECB interest rates. Furthermore, the Credit Suisse debacle has remained an isolated case within Europe. All these factors provide some temporary leeway for the ECB. Unless core inflation experiences a significant decline, it is realistic to expect at least one more interest rate hike, although resistance within the ECB Governing Council may intensify.”

“Allowing the Rate Hike to Take Effect” (July 2023)

The ECB Governing Council has decided on another interest rate hike of 25 basis points. This brings the interest rate for main refinancing operations of the banks to 4.25 per cent. Friedrich Heinemann, head of the Research Unit “Corporate Taxation and Public Finance” at ZEW Mannheim and professor at Heidelberg University, has commented on this matter:

“Calls for an end to interest rate hikes are premature. Unlike in the US, the inflation rate in the eurozone still exceeds the key interest rates. Savers, who are starting to benefit from higher interest rates on savings accounts, are still losing wealth in the current environment. Although the inflation rate is falling, core inflation – excluding energy and food prices – actually rose slightly in June. It would therefore be too early to give the all-clear on inflation at this stage. Nevertheless, it would be justified if the ECB now takes the decision to pause and allow the recent rate hikes to take effect before considering a possible further increase in October. By then, it will be clearer whether tighter monetary policy will finally dampen rising prices in the services sector as well.”

Contact

Scientific Contact

Prof. Dr. Friedrich Heinemann

Email Friedrich.Heinemann@zew.de Phone +49 (0)621 1235-149

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CvD

Yvonne Bräutigam, MSc

Email yvonne.braeutigam@zew.de Phone +49 (0)621 1235-322

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