“The Taylor rule requires the ECB to hike interest rates up to 7% at least”

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BrusselsReport.eu
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ECB President Christine Lagarde (Copyright: Brinacor, CC BY-SA 4.0 , via Wikimedia Commons )

Yesterday, Eurostat reported that “Euro area annual inflation is expected to be 7.0% in April 2023, up from 6.9% in March”.

Notably, Eurozone headline inflation slightly increased to 7% but core inflation, which includes food and energy, dropped to 5.6% from 5.7% month before. Observers noted that this means that “core inflation finally  peaked», which “makes a 25bp hike more likely over a 50bp this week», as the European Central Bank’s decision will be watched closely tomorrow.

The Financial Times reports that even if “Eurozone inflation ticked up for the first time in six months”, something which “has complicated the decision for rate-setters at the European Central Bank”, “analysts expect smaller ECB rate rises despite [the] uptick in inflation.”

In response, leading Dutch economics professor Lex Hoogduin, who has served as an advisor to the first President of the European Central Bank (ECB), Wim Duisenberg, as a member of the executive board of the Dutch Central Bank, and as chairman of clearing house LCH.Clearnet, stated:

“With actual inflation at 7% and core inflation at 5.6% in the Euro area and ECB interest rates at 3%, the discussion on whether the ECB should ease up on interest rate hikes is remarkable, to say the least. According to the Taylor rule, interest rates should be, say, 7-7.5%. This is not “rocket science” but it does indicate that the ECB is still playing catch-up.

Also compared to the Fed, ECB interest rates are low. The core inflation the US is targeting (core PCE) is lower than HICP core inflation, but the Fed funds rate is 4.75-5%, vs ECB 3% policy rate. Conclusion: to talk about smaller ECB interest rate steps, or even an end to this, is premature. The ECB probably needs to take several more 50-basis-point steps in order to be able to state with confidence that price stability will be restored.”

Meanwhile, writing in the FT, Krishna Guha, a former member of the management committee of the New York Fed, who’s now vice-chair of Evercore ISI, warns that the “ECB cannot afford to be complacent about European banks” as “European banks, like US ones, face large unrealised losses on assets acquired during the period of ultra-low interest rates that fell in value when interest rates shot up. As in America, some losses are on government bonds, but eurozone banks also hold a lot of fixed-rate mortgages.”

He adds:“While European supervisors stress tested banks for an interest rate shock (on the asset side of their balance sheets) they did not test for the other half of the stress that hit US regional banks — a simultaneous shock to the stickiness of bank deposits (on the liabilities side)” as “the underlying technology shock from mobile internet banking that allows customers to move deposits at the flick of a finger is present in Europe, too.

Moreover, Europe is worse placed to deal with such a twin shock were it to arise. Deposit insurance at €100,000 is too low, and there is no systemic risk exemption of the kind the US authorities invoked to protect all depositors and quell runs, while Europe’s single resolution mechanism for failing banks is too rigid.”

 

 

 

 

 

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