The Role of the European Central Bank in controlling Inflation

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Inflation can be defined as a general increase in prices in an economy or a decrease in the purchasing power of a currency. It is measured by the rate at which the cost of goods and services within the economy increases. As of February 2023, inflation within the Eurozone was at 8.5%, slowly decreasing from the 10.6% of October 2022 but still at one of the highest levels since the adoption of the single currency. However, the core inflation rate, which is calculated excluding the most volatile goods (i.e., food, energy, alcohol, and tobacco) to have a more precise indication of medium-long term inflation, reached 5.6% in February 2023, its highest level ever. High inflation levels are detrimental to a country as they create uncertainty, complicate investment decisions, and hurt consumers' purchasing power.

Core inflation rate within the Euro Area, source: Eurostat, retrieved on Tradingeconomics.com

Fighting this general increase in prices is nowadays one of the main challenges the European Central Bank (ECB) must face. Created in 1998 to manage the monetary policy within the Eurozone, its primary objective is to maintain price stability and preserve the purchasing power of the Euro (i.e., inflation at 2% in the medium term). To fulfill its mandate, the ECB mainly acts by deciding the interest rate at which it lends money to commercial banks, which also influences the inter-banking interest rate. In this way, when inflation reaches high levels, increased interest rates make borrowing more expensive, decreasing the liquidity circulating in an economy and cooling it down. By doing so, it decreases the country's aggregate demand, which helps to reduce inflation. On the other hand, when inflation is too low (harmful to the economy since it also can discourage consumer spending and investment), the ECB can lower interest rates to stimulate economic growth and increase demand for goods and services. The current rise in prices is driven by multiple factors affecting both the demand and the supply side. The fast reopening after the Pandemic, the supply chain disruption due to several lockdowns worldwide, and the Ukraine-Russian War that started in February 2022 all impacted this process substantially.

From July 2021 onwards, the inflation rate in the Euro Area exceeded the 2% threshold and has persistently remained at elevated levels. This phenomenon is particularly peculiar within Europe. Since the Euro was created, especially in the last decade, the Eurozone has been characterized by low inflation rather than a consistent and substantial price rise. To sustain the economy and ensure credit was available in the economy, the European Central Bank had to develop new unconventional policy tools to operate in a context with extremely low-interest rates (close to the zero bound limit). The two primary examples are quantitative easing (buying large quantities of assets, particularly government bonds, to increase the money supply and give liquidity to the market) and negative interest rates on deposits (charging banks for holding deposits at the ECB). While operating the European Central Bank also has to keep in consideration the issue of having a single monetary policy for multiple countries without a single fiscal union. Since different countries might experience non-simultaneous business cycles, adopting a unique monetary policy might cause economic tensions, especially in countries with high debt-to-GDP ratios. This has led to debates over the appropriate level of interest rates and other policy tools, with some countries arguing that the ECB's policies are either too restrictive or too accommodative. In this period of persistently high inflation with possible problems in countries’ refinancing due to rising interest rates, every decision must be timely and precise to avoid another emergency, like the Debt Crisis started in 2009.

This rising inflation, due to the global nature of its causes, impacted the majority of the world, pushing several Central Banks to intervene. For example, the Bank of England started raising interest rates in December 2021, while the Federal Reserve did the same in March 2022. Currently, interest rates are at 4.25% in the United Kingdom and 5% in the United States. These two banks had to act previously than what was done at the European level due to an anticipated and more vigorous rise in prices. Also, because of its more fragile economy and the need to satisfy all the countries of the Eurozone, the ECB started raising interest rates only in July 2022 and bringing them up “only” to 3.5% (rate on main refinancing operations) as of right now. Additionally, Central Banks also implemented another type of measure. To reduce the enormous amount of liquidity injected into the economy in the last decade through quantitative easing, an opposite program was put in place called quantitative tightening. It consists in reducing the balance sheet of the Central Bank mainly by selling their assets or waiting for their natural expiry date without reinvesting that money.

These policies showed their effects on the market, especially in the last few weeks when multiple commercial banks started to show their fragility. First of all, some regional banks in the United States, such as Silicon Valley Banks (SVB), suffered huge profit losses from the US bonds they were holding (a consequence of the increase in interest rates). Their clients rapidly tried to withdraw their money, and since a bank does not store the totality of their clients’ money, they were forced to declare bankruptcy. A few days later, tension also appeared in Europe when Credit Suisse, differently from SVB, suffered from the market's worsened credit condition, risked failing, and had to be bought by another Swiss bank, UBS. Fear soon spread to the market, hitting, in particular, other more fragile banks such as Deutsche bank. Through multiple press releases, the ECB stated how they are confident in the stability of European economies and their readiness to face this turbulent period. Furthermore, they also coordinated with other Central Banks to implement tools to provide liquidity to ease strains in global funding markets. However, these measures aimed at giving credit to financial institutions and avoiding their possible collapse are somehow in contrast to fighting inflation. It is another problem that adds up to the work of the ECB. They need to balance the two needs to avoid uncontrolled high inflation on one side and stop a banking crisis on the other.

In conclusion, the ECB is facing a challenging environment where various shocks are driving inflation, and it is dynamically adjusting to these shocks to bring inflation back down to its target. In its macroeconomic projection of early March 2023, inflation is projected to average 5.3% in 2023, before decreasing to 2.9% in 2024 and 2.1% in 2025. This shows how, even if inflation is starting to show signs of weakness, the road to come back to the target is still long and complex. The ECB has implemented several measures to combat inflation, including raising interest rates and quantitative tightening. However, these policies have also resulted in increased market tensions and volatility, which were not considered in the previous projections and might “add additional uncertainty for the outlook for inflation and economic growth” in the Eurozone. Moving forward, the ECB must carefully balance its policies to prevent further economic emergencies while also ensuring price stability and supporting economic growth.