Why isn’t inflation responding to ECB interest rates?

The ECB’s latest rate increase brought the Deposit rate to 3.25% and the cumulative tightening to 375bp over the past ten months. In addition the Bank has also taken steps to reduce the size of its balance sheet and the degree of excess liquidity it is pumping into the euro banking system and from July will stop reinvesting any proceeds from maturing bonds bought under QE. Yet although headline inflation in the euro area has fallen from a peak of 10.6% to the current 7%, that largely reflects base effects from energy prices, with core inflation at 5.6% and showing no clear signs of easing.

The ECB’s policy actions have had a clear impact on credit and the housing market, both through the effect of higher rates on borrowing costs and via a substantial tightening in credit standards from the banking system-indeed the past six months has seen the sharpest tightening since the financial crisis. Yet although the ECB still expects inflation to fall it is clearly concerned about core inflation and noted in its recent monetary statement that in relation to their rate increases ‘ the lags and strength of transmission to the real economy remain uncertain’.

That uncertainty is highlighted in the ECB’s latest Economic Bulletin in a piece setting out the impact of higher rates as captured across three economic models used by the Bank. In one respect it is reassuring for the Governing Council as it shows that inflation does fall substantially in response to higher rates when using the average effect across the models, with the largest impact in 2024 and 2025. It takes time therefore for monetary policy to work, although the BoE and the Fed tend to highlight lags more than the ECB in policy statements.

However, the models also show a surprising large variation in how rates affect inflation and the real economy, highlighting the uncertainty surrounding monetary policy in the current environment, where inflation has been driven by supply shocks rather than a credit boom and where a high percentage of existing loans in many countries are at fixed rate. One model, for example, shows inflation falling by 0.8% next year, with another showing a much larger 3.5% fall . The latter also shows a 3.5% fall in real GDP in contrast to the former’s 1.75%.

One result of that uncertainty about the impact of monetary policy transmission to inflation is that the ECB appears to be putting far more emphasis on ‘the incoming economic and financial data (and ) the dynamics of underlying inflation’. So the latest inflation data has a big impact on policy rather than any staff projections of inflation in the future. This raises the risks of a policy error (i.e. tightening by too much and causing a large rise in unemployment ) particularly as the bank claims to be both data dependent but with ‘more work to do’ . At the time of writing the market is priced for rates to peak at 3.75% , or another two quarter point increases , but the majority of Council members would want to see clearer signs that core inflation is on a downward path before becoming comfortable with the idea of that rate as the peak.