Economist warns Malta might need to revise growth forecasts after ECB raised interest rates

Economist Philip von Brockdorff warned that Malta might have to revise downwards its growth projections for 2023 after the ECB raised interest rates again last week.

Maltese households with home mortgages, and local businesses holding investment loans, could find it harder to pay off their debts after the European Central Bank raised interest rates by 75 basis points last week.

The ECB said that it would be raising interest rates to ensure that inflation returns back to its 2% medium-term target.

The bank suggested that it will continue raising interest rates to dampen demand and guard against upward shifts in inflation expectations.

Von Brockdorff told MaltaToday the increase in interest rates was inevitable given the high rate of inflation in the euro area.

“The hike is the highest on record and this follows a much lower increase earlier this year. The question is whether the hike will actually bring inflation down to the target of 2% given it is being caused by supply side problems,” he said.

Businesses and households will think twice

But a key problem is that an increase in borrowing costs means businesses will think twice about their business and investment plans, while households will reprioritise consumption, according to von Brockdorff.

“Households and individuals will end up paying more on the repayment of their loans and unless their incomes are increasing at a rate higher than the increase in the borrowing rate and related costs, this could result in households and individuals spending less than was the case up to now,” he said.

“This could be significant given that one of the major drivers of our economy in the second quarter of 2022 was consumption. Malta’s economic growth rate in 2023 may need to be revised downwards as a result.”

ECB President Christine Lagarde: The increase in interest rates by 75 basis points was a historically aggressive move to counter inflation, which has shot up as a result of the Ukraine war (Photo: ECB)

At the euro-area level, von Brockdorff points out that the hike could slow down economic growth in the euro area because of the increase in borrowing costs.

“That said, the ECB would have assessed the effects of an interest rate hike of that magnitude on euro area economies. A recession may not occur in the months ahead but higher borrowing and credit purchasing costs will certainly have some effect on investment and consumption decisions,” he said.

In the local context, von Brockdorff notes that the euro interest rate affects the interest rate on the main refinancing operations, deposit facilities, and the marginal lending facility for banks in the euro area.

“Such facilities are not resorted to by the Malta-based banking system,” he said. “Nonetheless, the interest rate hike is likely to be followed by an interest rate increase in the borrowing costs for businesses and households in the Maltese economy.”

Von Brockdorff explained that this makes borrowing more expensive. If the costs aren’t absorbed by productivity gains, the added costs will be passed on to consumers.

This would cause “second-round effects”, meaning workers begin demanding higher pay to protect their way of life after an initial rise in prices. In Malta, this would mean trade unions pressing for wage increases or adjustment measures beyond the automatic COLA adjustment.

More expensive loans

Central Bank of Malta Governor Edward Scicluna agreed that this move will make the financing of investment and household mortgages more expensive. The rationale is that the less money people have to spend, the slower demand will be, helping to alleviate demand-side price increases.

“In the US this will drive their economy into a recession. In the EU, the situation is better with a stronger economy and less aggressive interest rate levels,” Scicluna said.

“Keep in mind that borrowing money at, say 3% when prices are going up at 7% or 9% leaves you with borrowing at a negative real rate of interest. Still, households will be negatively affected,” he said.

The interest rate hike will mean house loans will become more expensive

Sciclcuna said that at the last ECB Council meeting, “we were faced with forecasts of much higher inflation coming from higher gas prices but also from the demand side”.

According to this projection, inflation was set to persist over the medium-term target of 2%. “For this reason, the ECB showed its full resolve to fight inflation with the right instruments, starting with 75 basis points on top of the 50 basis points already in place from the previous meeting.”

Scicluna made it clear that raising interest rates would not have been effective a few months back with inflation being largely generated by rising business costs stemming from supply or geopolitical causes.

It is only when inflation is being driven by demand-side factors, such as people spending more, that rising interest rates could be effective.

“What we did instead was to reduce the monetary accommodation put in place for the pandemic and meant to support firms to survive,” Scicluna said.

Hike mitigates ‘extent not the cause’

But Bank of Valletta chairperson Gordon Cordina, an economist, warned that the increase in interest rates may mitigate “the extent, but not the cause, of the current extraordinary inflation” originating from the shock to energy and food prices from the Ukraine war.

“It is still early days to comment on the implications of these latest developments for the economy and the general public, in Malta as well as in other euro area countries because much will depend on the speed at which inflation in the euro area will be receding over the coming months,” he said.

Energy prices have shot up across Europe but Maltese consumers are not feeling the brunt because of millions in subsidies that government is spending to keep prices stable. Nonetheless, higher inflation in Malta is driven by above average food and service prices.

Higher interest rates help increase the demand for the euro by investors, thereby sustaining its value, Cordina said. This would improve the purchasing power of the euro for goods and services, especially resources that are imported from outside the euro area.

But higher interest rates could also result in increases in bank deposit and lending rates, which could lead to higher savings, lower expenditure and subsequently reduced pressures on prices, Cordina said.

It still has to be seen whether the shock therapy delivered by the ECB will reap the expected results. The ECB will continue monitoring developments and take decisions accordingly.

“Typically, economic activity would be influenced mainly by permanent changes in inflation and interest rates,” Cordina said.

How the ECB will act in the coming months will dictate whether the increase in monetary policy rates would turn into a permanent as opposed to a transitory situation.