The European Central Bank (EC) just announced its biggest rate hike ever, bringing it closer in line with central banks all over the world that have rapidly tightened monetary conditions to curb inflation. The 75-basis point increase marks a hawkish turn for the relatively dovish ECB, which held off on lifting rates at all until July, and that half-point hike only brought the bank's benchmark rate to zero.
However, some are scratching their heads over why the ECB made the decision, given its past and even most recent comments about the origins of inflation in the European Union. Over the last year, the bank's leadership has insisted that supply, rather than demand, is the primary cause of higher prices.
“If you compare the situation of the U.S. and that of Europe, and in particular in relation to inflation, inflation in the United States is largely driven by demand," ECB President Christine Lagarde said Thursday during a press conference. "In the euro area it is largely driven by supply, not exclusively, there is also a portion of demand in the sources of inflation but it is predominantly supply."
She also stressed again that rate hikes won't impact the main supply-related crisis facing the continent.
“I cannot reduce the price of energy," she said. "I cannot convince the big players of this world to reduce gas prices. I cannot reform the electricity market."
So what is the ECB expecting from rate hikes? In short, the goal is to make sure inflation expectations stay in check and to make sure that rate hikes are at least underway if inflation proves more lasting than the latest supply chain issues.
There were hints of the ECB's change of tune at the Jackson Hole Economic Symposium last month, when Federal Reserve Chair Jerome Powell spelled out the bank's own commitment to raising rates until inflation was brought under control. During that conference, Isabel Schnabel, member of the ECB's executive board, broke down her case for tightening.
"There are two broad paths central banks can take to deal with current high inflation: one is a path of caution, in line with the view that monetary policy is the wrong medicine to deal with supply shocks," she said. "The other path is one of determination. On this path, monetary policy responds more forcefully to the current bout of inflation, even at the risk of lower growth and higher unemployment."
Schnabel ultimately argued for the latter, saying the world was entering a period of "great volatility" and that hikes were the best way forward to ensure central bank credibility, hedge against the possibility of acting too late, and account for the uncertainty of inflation persisting longer than expected.
Some European economists reject this argument. Positive Money Europe, a nonprofit research and advocacy group, called the 75 basis point hike "misguided," and that there was little evidence to suggest that the EU was headed for a wage-price spiral along the lines implied by Schnabel.
The group also calls for a new model of monetary policy that actually sets different interest rates for different sectors. That way, demand could potentially be brought down in one area, while other areas could benefit from easier money — for instance, low-carbon energy sources.
"Blunt interest rate changes are inadequate to respond to supply shocks in a specific sector, " said Marc Beckmann, a researcher for the group. "If the ECB wants to become a part of the solution and not the problem, it needs a different strategy with, for example, lower interest rates for green investments and stronger coordination with fiscal policy."
As for how this might impact Americans, tighter monetary policy can sometimes strengthen a currency so one potential short-term impact could be that the Euro regains some of its recent losses against the U.S. dollar. However, the Euro actually fell further on the news, as Lagarde noted that the bank was not targeting the exchange rate. "We know it has a lagging impact on inflation," she said. "But we do not target the exchange rate. We have not done so and we will not do so."