Monetary policy: combating inflation is top priority

Forecast summary: Growth in real GDP 2022/2023 in percent

World

USA

China

Japan

EU

Euro area

Germany

France

Italy

Spain

U. Kingdom

India

Brazil

Russia

2022 2023

IMF1 OECD2 EUCOM3 IMF1 OECD2 EUCOM3

3.2 3.04 3.0 2.7 2.24 3.3

1.6 1.5 2.9* 1.0 0.5 2.3*

3.2 3.2 4.6* 4.4 4.7 5.0*

1.7 1.6 1.9* 1.6 1.4 1.8*

2.7 1.5

3.1 3.1 2.6 0.5 0.3 1.4

1.5 1.2 1.4 -0.3 -0.7 1.3

2.5 2.6 2.4 0.7 0.6 1.4

3.2 3.4 2.9 -0.2 0.4 0.9

4.3 4.4 4.0 1.2 1.5 2.1

3.6 3.4 3.4* 0.3 0.0 1.6*

6.85 6.9 7.4* 6.15 5.7 6.5*

2.8 2.5 0.7 1.0 0.8 1.5

-3.4 -5.5 -10.4* -2.3 -4.5 1.5*

1: IMF (October 2022) 2: OECD (September 2022), Forecast for India for fiscal year beginning April 3: European Commission (July 2022, *May 2022) 4: Forecast on basis of 70 percent world GDP (PPP of 2013) 5: Information on India for the fiscal year in current prices

Monetary policy: combating inflation is top priority

The central banks in the transatlantic region are combating inflation by rigorously tightening the monetary reins. The policy response to the dramatic upward trend in inflation has been stronger and swifter than in the past. In autumn and winter 2022/2023 we are likely to see further rapid and hefty interest rate hikes and other measures to further tighten the monetary course. Most central banks are trying to avoid interest rates settling well above the target level, which is a risk if inflation expectations of private households and wage negotiations adapt to the new level. A point of contention is how far the central banks need to go, especially as the impact of interest rate hikes and quantitative tightening along with the international feedback effects will only fully unfold in the later part of 2023 (Obstfeld 2022). The OECD estimates that the median cost of the concerted efforts will be about one quarter of a percentage point of growth and half a percentage point of inflation over the next two to three years

as the usual mechanism of taking independent action to curb the price level through an appreciation of the currency does not work in the collective case. In general, past experience will only be of limited use in finding the right dose of monetary tightening, so there is certainly a risk of either undershooting or overshooting. The consensus among the major central banks over the summer was that the reins should be tightened more rather than less.

FED tightening hard

Rapid interest rate hikes and quantitative tightening are the order of the day

The US Fed has tightened the monetary reins very rigorously since the beginning of the year, which is not surprising given that monthly inflation had climbed to over eight percent (consumer price index). The policymakers have already hiked the interest rate up by 3.75 percentage points since the beginning of the year and are expected to increase rates from their current level of between 3.75 and four percent up to 4.6 percent (median value) in spring 2023 (as of September). At the FMOC’s meeting on 1 and 2 November, the decision was made to increase interest rates by 75 basis points for the fourth time in a row. Governor Powell also indicated that yet more interest hikes are on the horizon (Fed 2022a). The OECD also believes that it will be necessary to raise interest rates to between 4.5 and 4.75 percent. The financial markets are already anticipating a further hike on this scale or even slightly higher. In addition, the Fed started on a course of quantitative tightening at the beginning of the year and has been reducing its asset portfolio. This should drive long-term bond yields up by between one half and one whole percentage point and have a corresponding tightening effect. The financing terms in the United States have also become considerably more restrictive and the rapid appreciation of the external value of the US dollar is putting an additional damper on economic activity.

Tightening already impacting financial markets and real economy

The monetary tightening has already affected bond yields and investments in the United States and is set to bring inflation down significantly in 2023/24, albeit at the price of a substantial cut in growth. In September, decision-makers expected an average inflation rate of 5.4 percent in 2022 and 2.8 percent in 2023 (with core inflation of 3.1 and 2.3 percent) (Fed 2022b).1 The labour market is still marked by tight supply and very high wage increases. Over the last two years, average hourly wages in the private sector have increased by between four and eight percent in most months. The ratio of vacancies to the unemployed dropped slightly from its all-time high of two to one before turning upwards again in September. Pressure on core inflation is set to remain high for the time being. Some observers expect the Fed to tighten the reins even more than anticipated so far and raise the interest rate to over five percent (Dynan 2022, Deutsche Bank 2022). The risk of economic output contracting more than forecast next year is therefore high.

ECB tightens monetary course

The strong upward flight of inflation has repeatedly taken the ECB by surprise this year. Following several months of debate, the ECB changed its monetary approach in the second quarter and over the following six months, it reviewed its entire toolbox of monetary policy. In a first step, the ECB stopped net purchases in its asset purchase programmes. It then increased interest rates and terminated its

1 The FED bases its calculations on the consumer spending deflator of private households, not the consumer price index, which is currently two percentage points higher (a good one percent for the core rate).

forward guidance. In October, it added measures to restrict the supply of liquidity to commercial banks. A review of the asset purchase programmes is on the agenda for December, with the aim of deciding the further course for the quantitative tightening of liquidity.

Interest rate hikes anticipated

The ECB is likely to raise the key interest rate (deposit rate) substantially from its current level of 1.5 percent by spring 2023. At present, the three interest rates stand as follows: the deposit rate is at 1.5 percent, the main refinancing rate at two percent and the marginal lending rate at 2.25 percent. How far the ECB will go will depend on the severity of the slump in economic activity and the expected slowdown of price increases in the Euro area. The ECB is currently still anticipating growth of 0.9 percent for the Euro area next year, but a more realistic perspective lies between this forecast and the downside scenario (minus 0.9 percent) (ECB 2022); the 2023 forecast will probably be downwardly revised again slightly in December. The markets expect a key interest rate (for the deposit facility) of between 2.5 and three percent in the first six months of 2023. The OECD believes the rate needs to be as high as 3.25 percent (OECD 2022).

In its meeting on 27 October, the ECB noted substantial progress in the downscaling of monetary accommodation but made it clear that further hikes were to be expected. The ECB also decided to raise the terms and conditions of the third series of targeted longer-term refinancing operations for credit institutions and offer banks additional voluntary early repayment dates to reduce liquidity in the real economy.

Discussion will soon become heated

Once the deposit interest rate climbs above two percent, public debate will become more strident as it will not be possible to precisely quantify the contrary effects (upsurge in prices in 2023 as energy purchase prices are transferred to consumers versus slump in economic activity and demand) and there is considerable factual uncertainty about the effectiveness of further interest rate hikes. In our opinion, the producer price trends indicate that Euro area inflation will continue to be very high in the first six months of 2023 and only gradually subside towards the end of 2024. Whether inflation can be reined in to an annual average rate of 5.5 percent depends largely on further developments in the security situation. Wage agreements will only lift inflation marginally in the foreseeable future, as the monthly increase in wages had not exceeded 2.5 percent by the summer and there are no indications of high wage agreements on the horizon. Although the ECB is expecting the wages of Euro area employees to increase by four percent this year and 4.8 percent next year (and four percent in 2024), the impact on inflation will remain limited. The ECB has nonetheless reasoned that the inflation expectations of citizens are too high, that higher interest rate hikes are required than in the past to achieve the same effects (the economy as a whole has become less sensitive to interest rate changes) and, in cases of high uncertainty, a more rigorous course is the better choice. Factors currently alleviating inflationary pressure are the oil and gas markets, although bottlenecks among refineries in Europe mean that the low Brent oil price will probably not have an even impact on final product prices. The ECB is also closely monitoring the external economic effects of US monetary policy. Much of the tightening of the financing terms in Europe is a direct result of US monetary policy (Lane 2022), although the contrary real economic effects of the appreciation of the dollar on production (increased net exports to the dollar region) and inflation (through import prices from the dollar region) need to be factored in. The ECB has nonetheless underlined that the risks for inflation and growth remain high. The further course of policy will be based largely on the new economic forecasts in December, EU

decisions on energy policy for the gas and electricity markets, the fiscal support measures of the member states for 2023 and the actual trends in bank lending.

Transmission channel uncertain and complex

After years of unconventional measures, the various transmission channels of the ECB’s monetary policy have become very divergent. This means that a change in course involves a degree of uncertainty (in that the retraction of unconventional measures does not always have the same effect in the opposing direction as the introduction of these measures). The ECB will therefore be keeping a very close eye on how its measures play out. It is already clear that construction and real estate financing has contracted more sharply than corporate financing, which was temporarily stimulated by special requirements but is likely to come under pressure in the next few months due to more restrictive lending standards, higher lending rates and the credit rating migrations typically seen during a downturn, even if the demand for corporate lending itself is also likely to drop. Lending to households and to the residential accommodation sector should decline more rapidly (see Lane 2022 for details).

Many other central banks towing the line

Some central banks have already sharply raised their interest rates. Canada has already hiked its interest rate by 3.5 percentage points to 3.75 percent. Hungary had to make a ten-percentage-point hike while Poland remains at five percent. The central banks of New Zealand, Australia, Norway, Sweden and Switzerland have also raised their rates substantially since the beginning of the year (by 2.75, 2.5, 1.75, 1.75 and 1.25 percent respectively). The Bank of England is also likely to increase its key interest rate from currently three percent to four percent or more (OECD 2022). Japan is the exception here with interest rates trending sideways around zero. China, meanwhile, is pursuing an expansionary monetary course to bolster its sluggish economy. The high inflation has also forced many central banks in developing and emerging countries to raise their interest rates substantially. Brazil had increased rates by as much as twelve percentage points since the start of 2021 (back to a good ten percentage points now), Mexico by six percentage points and South Africa by just two points. Russia’s central bank had initially raised the key interest rate considerably following the outbreak of the war but has since brought it back down again.

Difficult balancing act for fiscal policy

Support measures launched for households and enterprises

Most industrialised countries have launched quite extensive support measures. In many cases, the initial steps taken were not very targeted, consisting for example in general reductions in value-added tax on fuels and price interventions. These measures were often not tied to reducing the consumption of scarce commodities. Some countries are now gradually adopting more targeted support measures, a process that tends to be hampered by administrative and information-related obstacles. In general, low-income private households, the elderly and residents of rural areas are particularly affected and should receive most support. Support measures for the private sector tend to focus on energy-intensive enterprises; here too, the precision of the measures is crucial. The volume of these types of measures often amount to between two and three percent of GDP. In Germany, they are likely to add up to just over four percent of economic output in 2023 and will serve to stabilise economic activity. The measures taken by Germany, Italy and France in particular, do however, raise general questions about competition in the EU, especially as the response to the crisis, as in the case of Covid, is much stronger