VOne and a half percent. This is the interest rate at which the fastest interest rate hikes in the history of the European Central Bank could come to an end. This is how one should understand what ECB President Christine Lagarde said last Thursday. The decision is not yet final, and the ECB is keeping a large backdoor open in case things turn out differently than expected. However, the benchmark interest rates are supposed to stay at 4.5 percent for a while and are unlikely to rise further. This is how investors in the financial markets interpreted the words of the central banker.
The stocks rose because the companies do not have to pay higher interest rates for their loans in the near future. On the other hand, the value of the Euro decreased because Euro deposits are no longer being highly rewarded. However, all of this should not be a concern for the ECB. Its main objective is to control inflation – can it really be said that inflation has already been defeated? After all, the inflation rate in Germany was still over six percent in August. What evidence does the central bank have to believe that price increases do not need to be further combated?
The cost of gas is lower, prices are decreasing in the agriculture sector.
First, there is the price development for energy. Gas is much cheaper on the wholesale markets than last year, and German gas storage facilities are already almost full, several weeks before the heating season begins. Electricity is also significantly cheaper than in September 2022. All of this continues to push down the inflation rate – especially since the food prices, which are currently driving up the inflation rate, can hardly become more expensive. As economist Timo Wollmershäuser at the Ifo Institute for Economic Research notes, prices in agriculture have been declining since the beginning of the year.
And then there is also the recession. In Germany and some other parts of the Eurozone, the economy is no longer growing strongly. Private individuals can hardly afford new buildings anymore, companies are scaling back their investments, construction companies are going bankrupt. Companies find it much more difficult to implement price increases with customers. In this way, interest rate hikes usually have an effect.
What about the job market?
But isn’t this time something different than usual? Namely, the job market? Recession or not – so far, unemployment has hardly increased. At least in the German economy, there is still a massive shortage of personnel, even after two years of inflation, and the demographic development will ensure that this worsens in the near future. Accordingly, salaries are rising. The collective bargaining agreements are generous, and many employees can also negotiate their own salary increases. In the spring quarter, wages for employees in Germany increased by 6.5 percent, even faster than prices.
This has two consequences at once: Firstly, companies are being pushed to further increase their prices. And secondly, they can enforce these more easily, as the purchasing power of Germans has increased again. All of this could particularly drive up the prices of labor-intensive services in the coming months, even the central bank suspects.
But then she hopes for an effect that ECB President Christine Lagarde had actually criticized: the inflation of profits. At the beginning of the recent round of price increases, the revenues of many companies rose faster than wages. Some companies in Europe even raised their prices faster than their costs for energy and raw materials. This allowed them to increase their profits. Now the trend is changing: for the first time, profits have fallen again, according to Lagarde. So the hope of the central bank is that companies could pay for wage increases at least partially from their profits instead of further raising prices. „This is a normal process,“ says Stefan Kooths, Chief Economist at the Institute for World Economics. „Wage income has not kept pace recently, now workers are reclaiming their share.“
However, this consideration still has an uncertainty: Not all companies have seen such an increase in profits. Many construction companies have had huge profits in recent years, but this trend could not be found in the published financial statements of large German corporations. The companies showed very different tendencies. In the industries where profits have not grown as much in recent months, there is now also a lack of leeway to pay salary increases from the profits.
The central bank hopes that the combination of all these effects will lead to a decrease in inflation in the Eurozone to 3.2 percent next year, followed by a return to 2.1 percent the year after. The ECB is not more optimistic than many other economists in this regard, as they also observe similar trends for the near future. Recent surveys conducted by the Ifo Institute indicate that companies themselves believe that price increases have reached their peak.
Even if reality aligns with the predictions, it also means that inflation is not yet defeated. According to current forecasts, price increases would still be above the ECB’s target in the coming year. On the other hand, it is also known that interest rate hikes by central banks do not have an immediate effect. The exact duration is not entirely certain, but it is measured in quarters. This also means that the recent interest rate hike will likely only fully impact next year.
This means that even if everything goes as planned by the ECB, prices will continue to rise for a while. And if the plans do not materialize, prices may rise even longer. Oil exporters have recently reduced their production, and oil prices are rising again. Let’s hope that the ECB also reacts if inflation remains stubborn – it has promised to do so, at least.