European Central Bank President Christine Lagarde was speaking to the European Parliament’s Economic and Monetary Affairs Committee this week (on 25.09).
Predictably, there were many questions on the potential negative impact of high interest rates on the economy, especially the so much needed green investment.
There is nothing new to this discussion, it continues for more than a year now. Yet, on the basis of the last two years of experience of fighting with inflation, there are some obvious things that are surprisingly not part of high-level discussions.
The striking fact is that with the same monetary policy, Euro-area countries happened to have very divergent inflation performance. From the chart below we see that Spain and Belgium have the lowest levels of inflation currently (August data). Spain in fact was able to calm down its inflation by spring 2023 (3.1% in March). Belgium case is interesting, as it has an automatic indexation of wages to the inflation level, yet it did not translate into a “perpetuating circle” of wage-driven inflation. France is notable for the lowest “maximum” level of inflation – the worst it had during this spike was 7.3%. We know that Spain and France introduced caps on electricity prices early on in the crisis, and this has obviously helped. By contrast, Latvia and Lithuania liberalized their electricity markets just before the crisis, and this probably did not help. Estonia’s electricity has been fully liberalized much earlier.
What this picture tells us is that national policy responses were a decisive factor in the fight against inflation. If all countries were quick and decisive in the application of competition policy and regulations, the ECB job would be much easier and there would be no need for drastic interest hikes. It is the lack of regulatory policy response that failed us.
Yes, hiking interest rates in the face of the supply shock is not very productive. But this is the only thing a central bank can do to fight inflation. Lagarde also justified it in today’s responses by the need to anchor inflation expectations. Instead of blaming the ECB for insensitivity to economic plight, the attention should go to what can be done on the supply side. For this round of inflation, it is almost too late, but we need to prepare for possible new shocks. It takes time to reform markets, so it’s better to start now.
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