The latest increase in interest rates to 4.5% in the euro zone seems to have exhausted the main tool of the European Central Bank (ECB) to contain inflation. Raising the price of money further could be too harmful to the economy. However, the central bank can now play with an additional factor: time.
That is precisely what the governor of the Bank of Spain, Pablo Hernández de Cos, claims in the first entry of the blog recently launched by the institution. He same dose, but for longer so that “the genie of inflation” ends up returning to “his lamp” of him.
The key, as he says in his article, is not so much to continue pushing the rate lever as to keep it as it is. “The current level of interest rates, if maintained for a long enough period, would be consistent with achieving our inflation target of 2%,” he says.
This vision, he assures, is shared by “analysts and financial markets”, and can be consolidated as the new slogan of the ECB in the coming months. One of them is Adrià Morro Salmeron, from CaixaBank Research, who appreciates “implicit expectations in the financial markets” according to which the ECB would maintain current rates “until the third quarter of 2024, when a first cut could occur.”
The governor of the Bank of Spain considers that “uncertainty about the evolution of the economy and inflation remains high”, and is also conditioned by factors that are “difficult to anticipate”, including the evolution of the war in Ukraine.
The danger is that “when the genie of inflation leaves its lamp, it becomes more and more difficult to return it,” and that is now the fear, indicates De Cos. In his resistance to returning to the lamp, the genie describes the famous second-round spirals that concern the Bank of Spain so much.
“Wage increases to regain purchasing power entail additional increases in production costs; in turn, companies try to pass them on to sales prices to protect their margins. These second-round effects could trigger a price spiral and wages that are more difficult to stop,” says the governor.
The spiral does not end there because “economic agents may think that inflation will continue to be high and revise their expectations upwards,” which in turn would raise prices and “make it difficult to reduce inflation.”
High inflation for a long time, recalls the governor, damages growth and widens inequalities. “Protecting themselves from inflation is more difficult for households with fewer resources,” he notes.
De Cos also indicates that the rate increases already agreed upon are yet to be fully transmitted to the economy, despite contributing to stagnating economic growth. Core inflation has also been contained, which allows “gaining confidence” in containing price increases.
