EUROPEAN CENTRAL BANK RAISES HALF-POINT RATE FOR THE FIRST TIME IN 11 YEARS

July 7, 2022

Linh Truong

NEWS

Source: CNN Business, The Guardian

The European Central Bank (ECB) has raised rates for the first time since 2011 to take the eurozone inflation under control. The rates have been negative since 2014 and are taken back to zero.

Euro inflation increased to 8.6% for 19 countries that use zero. The ECB rose the interest rates by 0.5 percentage points. Due to ECB President Christine Lagarde at the press conference, inflation rose higher than what they had previously expected, the shortage of gas and the surging prices of food and fuel for months so they had to increase rates above the target. She also affirmed that the central bank’s monetary policy decisions will be taken month-by-month and step-by-step.

ECB officials were forced to raise borrowing costs under the pressure from the officials of Germany, Dutch and Austria. The collapse of Italy’s government increased the proportionate cost of Rome’s borrowing and weighed heavily on the ECB. The ECB unveiled a new bond-buying instrument to counter unwarranted, disorderly market dynamics that pose a serious threat to the transmission of monetary policy in euro countries.

ANALYSIS

What did Europe have to face?

The Eurozone faced galloping inflation. Cost of living in Europe increased rapidly so households experienced deep financial issues.

The Ukraine - Russia war halted or lowered the supply of energy and gas so prices of energy and gas escalated. The looming energy crisis pushes Europe to the extent of raising rates.

What can we expect from the rate hikes?

The economic growth will be slowed down so that the inflation will be curbed. Since the rates go up, prices will be higher so consumer surplus will be shortened down. Consumers will lower their demand and consumption will decrease.

The costs of energy in Europe peaked since the supply from Russia was halted after the war between Russia and Ukraine alongside with the temporary pause of the main gas pipeline from Russia. Heated geographical conflicts resulted in higher costs amounting to inflation. Higher interest rates will raise the costs of gas and electricity in Europe which might curtail the energy consumption which then hopefully brings down prices.

With higher interest rates, European banks will have greater money supply to navigate the economic crisis. Banks will see profits and boost net margins.

The rate hike decreases the demand for borrowing since the costs of borrowing are more expensive. To have enough source of money for loan demands, banks have to borrow money from the central banks. The Central Bank increases the key rates and the rates are the benchmark for interests of banks. Banks will raise their rates for loans which results in fewer demands for borrowing. When customers take out fewer loans, banks will offset their borrowing from the Central Bank so that the monetary supply will decrease. The supply of euro decreases so that the value of the European currency will increase. If the euro rises in value, prices in the markets will decrease.

Moreover, when the interest rates increase, the interest rates of deposits will also rise. People will start to open more savings accounts and deposit more money. This will result in the decrease in spending because consumers choose to save their money instead. The fall in consumption equates the fall in demand for goods. As a consequence, prices will decrease. This is the sign of an economic slowdown so that inflation will fall. And for customers who had their money saved in deposit accounts, their assets will rise.

It will be bad news for the stock market because share prices will turn red because firms suffer from financial crises as a result of lower revenues and higher debts. However, for stock investors, it might be good news since they could buy stocks with lower prices and wait until the market thrives again to sell them with great interest.