After the first interest rate hikes in the United Statesexpected let the European Central Bank do the same in summer. But will the solution be just as effective, or does it depend on how the inflation was generated? Does it affect us all the same? Does it depend on whether our profile is more saver or debtor? What components make up (nominal) interest rates?
Those who save and those who spend
First of all, we are going to identify two different profiles of economic agents (which can be families, companies or public administrations):
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Savers, who spend less than their income allows.
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Debtors, who spend more, so they have to borrow.
The rise in rates will affect each other differently.
Those who save have available resources that, if interest rates rise, could be paid at a higher rate. A priorisavers will be better off if interest rates rise.
However, the final effect of a rate hike on debtors is not so clear: their situation may worsen but also improve, although the latter may seem counterintuitive.
American inflation vs. european inflation
In the United States, the increase in inflation was determined, in principle, by the demand side. With an economy close to full employment, the demand for products exceeds the supply. Faced with this situation, prices must rise to balance the balance. When many people want a product but it is scarce, its price goes up. And it is what has been happening from mid-2021.
Although since the end of 2021 there had been an escalation in prices, the inflation in europe it has been aggravated by Russia’s war against Ukraine.
The conflict has caused an increase in energy prices, as well as shortages in the supply of other essential products. This is, therefore, an inflation on the supply side. When there is little quantity of a good (whether energy, agricultural or industrial) and many people who want to buy it, then its price rises. And hence the emergence of supply-side inflation in Europe.
How to protect yourself or take advantage of the rate hike?
First of all, we must make it clear that we are talking about nominal interest rateswhich include several components, the most important being the (real) interest rates themselves and inflation expectations:
Nominal = Real + Expected Inflation
The real interest rate can be defined as the remuneration in terms of purchasing power for making a certain amount of money available to a third party during a certain period of time, that is, for lending money.
Therefore, if the ECB raises interest rates (which we have identified as nominal) to try to tackle inflation, this could cause real interest rates to increase, remain constant or decrease, depending on whether the increase is greater, equal to or less than the increase in inflation. If nominal interest rates and inflation rise in a similar way to the rise in rates, it could not have any effect on economic agents.
However, so that the rate hike does not negatively affect purchasing power (let’s not forget that this rise is due to an increase in the inflation rate), it should be accompanied by a revaluation of salaries, pensions, benefits of companies and, in the case of public administration, tax collection.
In this way, even if the prices of products and services increased, this increase would be offset by higher income through the increases that would also be experienced by the payrolls of workers and pensioners, as well as the benefits of companies and the collection of the public administration.
At a micro level, what interests us is to see the impact on households, the Administration and companies, of the combination of the increase in nominal interest rates and the behavior of inflation. That is, real interest rates, as this will determine who will benefit or lose from the interest rate policy and other elements of the ECB’s monetary policy.
At the macro level, depending on the nature of the shock inflationary, the rise in interest rates will be more or less effective in reducing inflation. It is already known that economists find it difficult to agree…
Expectations and forecasts
In order to identify the possible future scenarios, we have to review the expectations regarding interest rates and the inflation rate, taking into account that the expectations reflect the fear of the markets and economic agents about possible risks in the near future. Thus, the question is, given the current situation, how do economic agents and markets expect that inflation behaves but also interest rates in the coming months and years?
The data on inflation expectations can be extracted from the financial markets in which quote inflation such as the financial swaps (swaps) of inflation or the inflation indexed bonds.
Information about the swaps of inflation taken from the Thomson Reuters Eikon database as of May 23, 2022, indicates an inflation of 6.5% for the euro zone within a year. Average inflation is expected to be 4.5% in two years and 2.5% year-on-year. In other words, the bulk of the fall in inflation is postponed beyond twelve months.
Same measurement, different results?
Inflation in Europe is a consequence of the increase, above all, in energy costs, which is why it has a different origin than that which has occurred in the United States, where it has been determined by the increase in demand.
In the US case, an increase in interest rates could help cool the economy by raising the cost of borrowing, reducing economic activity and dampening demand for products, which would cause prices to fall. This measure would solve the problem without causing any economic crisis.
However, in the European case, an increase in interest rates could make it possible to control inflation, but, by containing consumption, it would lead to an economic slowdown. Being an inflation that is not caused by an overheating of the economy but, above all, by war and scarcity, its cooling could lead Europe to a new economic crisis.
We hope that the European authorities know how to dose the measure so that the effects are as desired.
Francisco Jareno CebrianUniversity Professor, Financial Economics Area, Department of Economic Analysis and Finance, Castilla-La Mancha university Y Eliseo Navarro ArribasProfessor of Financial Economics, University of Alcala
This article was originally published on The Conversation. read the original.