The growth in inflation has led the US to raise interest rates for the first time in 22 years and Europe is preparing for this. But the causes of the rise in prices are different and so can the consequences of the rise in rates.
After the first rate hikes in the United States, the European Central Bank is expected to do the same in the summer. But will the solution be just as effective, or does it depend on how inflation was generated? Does it affect us all the same? Does it depend on whether our profile is a saver or a debtor? What components does the (nominal) interest consist of?
First, we are going to identify two different profiles of economic agents (these could be families, companies or government departments):
– Savers who spend less than their income allows.
– Debtors, who spend more, so they have to borrow.
-The rate increases will influence each other differently.
Those who save have resources that can be paid at a higher rate if interest rates rise. A priori, savers will improve their situation if interest rates rise.
However, the ultimate effect of an interest rate hike on debtors is not so clear: their situation can worsen but also improve, although the latter may seem counterintuitive.
In the United States, the rise in inflation was basically driven by the demand side. With an economy close to full employment, the demand for products exceeds the supply. Faced with this situation, prices have to rise in order to balance the equilibrium. When many people want a product but it is scarce, the price goes up. And that is what has been happening since mid-2021.
Although prices have risen since late 2021, inflation in Europe has been exacerbated by Russia’s war against Ukraine.
The conflict has led to a rise in energy prices and shortages in the supply of other essential products. This is therefore an inflation on the supply side. If there is a small amount of a good (be it energy, agriculture or industry) and many people want to buy it, its price rises. And hence the rise of supply-side inflation in Europe.
First of all, it should be made clear that we are talking about nominal interest rates, which contain several components, the most important being the (real) interest rates themselves and the inflation expectations:
Nominal = real + expected inflation
The real interest rate can be defined as the purchasing power fee for making a certain amount available to a third party for a certain time, i.e. for lending money.
If the ECB raises interest rates (which we have identified as nominal) to address inflation, it could cause real interest rates to rise, remain constant or fall, depending on whether the rise is greater, equal to or less than the rise in inflation. If nominal interest rates and inflation rise in the same way as interest rates rise, this could have no effect whatsoever on economic agents.
To ensure that the rate hike does not negatively affect purchasing power (let’s not forget that this rise is the result of an increase in inflation), it must be accompanied by a revaluation of salaries, pensions, company benefits and, in the case of public administration, tax collection.
In this way, even if the prices of products and services were to increase, this increase would be offset by higher incomes through the increases that would also be experienced by the payrolls of employees and retirees, as well as the benefits of corporations and the collection of public administration.
What interests us at the micro level is to see the impact on households, government and businesses of the combination of the rise in nominal interest rates and inflation behaviour. That is, real interest rates, as this will determine who will benefit or lose from the ECB’s interest rate policy and other elements of monetary policy.
At the macro level, depending on the nature of the inflation shock, the rise in interest rates will be more or less effective in curbing inflation. It is already known that economists find it difficult to agree…
To identify possible future scenarios, we need to review expectations regarding interest rates and inflation, bearing in mind that expectations reflect the fears of markets and economic agents about possible risks in the near future. So the question is, based on the current situation, how do economic actors and markets expect inflation to behave, but also interest rates in the coming months and years?
The data on inflation expectations can be extracted from the financial markets on which inflation is quoted, for example the financial swaps (swaps) of inflation or the inflation-indexed bonds.
Information on inflation swaps from the Thomson Reuters Eikon database as of May 23, 2022, indicates an inflation rate of 6.5% within one year for the eurozone. Average inflation is expected to be 4.5% over two years and 2.5% year-on-year. In other words, most of the inflation decline is delayed beyond 12 months.
Inflation in Europe is a result of the rise in energy costs in particular and therefore has a different origin from that in the United States, where it was determined by the increase in demand.
In the case of the US, a rise in interest rates could help cool the economy by increasing the cost of borrowing, reducing economic activity and dampening demand for products, causing prices to fall. This measure would solve the problem without triggering an economic crisis.
In the European case, however, a rise in interest rates could make it possible to contain inflation, but by curbing consumption, this would lead to an economic slowdown. Like inflation caused not by an overheating of the economy, but mainly by war and scarcity, its cooling could lead Europe into another economic crisis.
We hope that the European authorities know how to dose the measure so that the effects are as desired.
This article was published in ‘The conversation
Source: La Verdad
I’m Wayne Wickman, a professional journalist and author for Today Times Live. My specialty is covering global news and current events, offering readers a unique perspective on the world’s most pressing issues. I’m passionate about storytelling and helping people stay informed on the goings-on of our planet.
