ECB to respond with historic rate hike in bid to cool down price inflation

Interest rates will exit negative territory by September as the European Central Bank gets ready to start hiking the rates in response to price inflation now hitting the pockets of businesses and consumers.

Stuck at a historic low of -0.5% for years since the start of the financial crisis of 2008, this would be the first interest rate hike since 2011.

Edward Scicluna, governor of the Central Bank of Malta and a member of the ECB’s Governing Council, said the ECB had act now in the face of high inflation rates, by stopping asset purchasing programmes. This brings to an end an era of quantitative easing started in response to the European sovereign debt crisis.

Edward Scicluna warns of risks from prolonged war in Ukraine

The ECB wants inflation to return to a 2% target over the medium term. In May inflation again rose significantly, mainly because of surging energy and food prices, including due to the impact of the war.

But inflation pressures have broadened and intensified, with prices for many goods and services increasing strongly.

The ECB said its projections indicate that inflation will remain “undesirably elevated for some time. However, moderating energy costs, the easing of supply disruptions related to the pandemic and the normalisation of monetary policy are expected to lead to a decline in inflation.”

The new projections foresee annual inflation at 6.8% in 2022, before it is projected to decline to 3.5% in 2023 and 2.1% in 2024.

The ECB said Russia’s unjustified aggression towards Ukraine had disrupted trade, leading to shortages of materials, and contributing to high energy and commodity prices.

But it said conditions were in place for the economy to continue to grow on account of the ongoing reopening of the economy, a strong labour market, fiscal support and savings built up during the pandemic. “Once current headwinds abate, economic activity is expected to pick up again. This outlook is broadly reflected in the Eurosystem staff projections, which foresee annual real GDP growth at 2.8% in 2022, 2.1% in 2023 and 2.1% in 2024. Compared with the March projections, the outlook has been revised down significantly for 2022 and 2023, while for 2024 it has been revised up.”

Threat of stagflation

EMCS director of advisory Silvan Mifsud says the current climate has all the right ingredients for a period of stagflation – a period where high inflation occurs in a stagnant economy not because of high demand, but by sharp increase in commodity prices brought on by a supply disruption.

In this, the post-COVID supply disruptions and the war in Ukraine are whipping up a perfect storm.

“Once stagflation arrives, it creates the dual challenges that squeeze businesses as they have to deal with softening customer demand, while costs rise from inflation – making it a very tough environment to run a business,” Mifsud writes in his blog.

“Those businesses who successfully adapt to stagflation may find themselves better positioned for the economic boom times that normally follows.”

Stagflation occurred in the 1970s when an Arab-led Organization of Petroleum Exporting Countries (OPEC) imposed an oil embargo to reduce the supply of oil to the United States from October 1973 to March 1974. Oil prices shot up, and with it price inflation; expensive fuel meant less money in peoples’ pockets, hurting businesses and in turn the economy. And inflation eroded wages’ purchasing power, leading to union unrest. Businesses raised consumer prices and laid off workers to meet higher energy costs and demands for higher wages. “It all resulted in a nasty wage-price spiral,” Mifsud writes. “The results was a global economic recession between 1973 to 1975.”