“No Time to Tinker”
Knot: ECB must act against inflation

08/30/2022, 7:40 pm

Inflation in the euro area is at record levels and is rising again in Germany. The European Central Bank now wants to take decisive action against inflation. Interest rates are sure to rise sharply.

According to Klaus Knott, the head of the Dutch central bank, the European Central Bank (ECB) should take strong action against the huge jump in inflation in the euro area. “There is no time for manipulation. We must resolutely tackle the growing problem of persistent high inflation,” Knott said at a round table conference organized by Danske Bank. A rapid increase in interest rates is a necessary first step. According to Knott, it should not be ruled out that interest rate hikes will be carried forward.

This process is often referred to by currency watchdog as front-loading. From the point of view of an ECB Governing Council member, the Euro Central Bank may have to raise interest rates above the so-called neutral level to fight inflation, at which the economy neither warms nor dampens. When asked about his views on the ECB’s possible next rate hike on 8 September, Knott indicated that he was leaning towards a much larger increase of 0.75 percent. But he is open to discussion, he said.

Several central bankers, including Nott, recently spoke in favor of discussing the same rate hike in view of the deteriorating inflation outlook. Estonia’s central bank chief Maddis Müller also joined on Tuesday. “I think there should be 75 basis points for September because the inflation outlook has not improved,” an aide to the Notts ECB council said on the sidelines of a conference call in Alpbach, Austria. “We should not hesitate to take monetary policy measures because inflation has been very high for too long and we are still well below neutral interest rates,” Mueller said.

Rate hike for the first time in eleven years

Central bankers currently keep the neutral interest rate level between one and two per cent. Until recently, capital markets were still expecting a similar move at the July meeting. At that time, the ECB had initiated interest rate changes and raised key rates by 0.50 percentage points. The prime interest rate is currently 0.50 percent. This was the first increase in eleven years. According to statements made by several ECB central bankers, speculation on the stock exchanges has escalated to an even bigger step.

How a decision takes place in early September should depend in particular on new inflation data for the euro area in August, which is expected this Wednesday. In Germany, the largest economy in the currency sector, inflation is on the rise again despite fuel discounts and a 9-euro ticket: the rate of inflation rose to 7.9 percent in August, after 7.5 percent in July. This is considered a bad omen for the fall, when the gas levy will further burden the citizens.

That’s why economists are calling on the ECB to make a very strong interest rate hike on 8 September. “Hopefully the ECB will manage to raise the interest rate by a large 0.75 percent at its meeting next week,” said Commerzbank’s chief economist, Jörg Kramer. VP Bank’s Thomas Gitzel also believes a bigger move is necessary. “Given the current inflation rate and what is yet to come, the ECB should really introduce a jumbo rate hike,” he said.

Inflation at record high in euro area

From Nott’s perspective, the ECB should initially raise interest rates to a neutral level of one to two percent this year. But he is not convinced that this is enough to curb inflation, he said. The central bank may have to switch to a restrictive monetary policy. According to Knott, the latest indicators are pointing to a slowdown in the economy. “However, even if this moderation does occur, it may not be enough to bring inflation back towards our medium-term target,” he added. Inflation in the euro area rose to a new record high of 8.9 percent in July. This is more than four times the ECB’s target of two per cent inflation.

In Knott’s view, the central bank should also consider shrinking its balance sheet, which has been bloated in recent years by trillion-dollar bond purchases. This may be due, for example, to the fact that funds from bonds that have expired in the APP purchase program are no longer fully reinvested, he explained. But it will happen gradually, he said. Talks in this regard are likely to start in October or December.