BarcelonaThe quorum among the central banks of the most advanced economies is absolute: the escalation of prices in recent months must stop and the way to do so is to raise interest rates. However, with most countries leaving behind two years of pandemic, the rises are not without risks.
The exit from the pandemic has left increases in the consumer price index (CPI, the indicator that calculates the price of goods and services consumed by households) at record levels for four decades. In Spain it closed in June 10.2% above a year ago, with an underlying rate – which does not include food or energy, more volatile – of 5.5%.
To counter this situation, the classic way out of central banks is to raise basic interest rates, which is what commercial banks have to pay to borrow money from the central bank. A rate hike makes it more expensive for banks to borrow money, which is transferred to the loans they offer to their customers, who pay more interest. And an increase in credit causes consumption and investment to fall.
Since March, the Federal Reserve – the central bank of the United States – has approved three increases in basic interest rates totaling 1.5 percentage points. For its part, the European Central Bank has announced a first increase of a quarter of a point for July and a second – which will be a quarter or a half point – for September.
The main criticism of this year’s rate hikes is that they will affect demand when the problem comes from supply: energy prices have skyrocketed following the Russian invasion of Ukraine, not a excess consumption. In fact, the great inflationary episodes of the 70s and 80s were caused by the same thing: an increase in the price of oil. A rate hike will not attack the cost of energy, it will simply make credit more expensive for businesses and households, but gas and oil will remain expensive.
Ernest Pons, professor of economics at the UB, believes that rate hikes should be “accompanied by fiscal policies so that they affect less those who can suffer the most”, either with subsidies or with “selective tax reductions” in the more disadvantaged. So far, in Europe some governments have approved raising taxes on energy companies to subsidize price reductions, while others, such as the Spanish, have applied caps and bonuses.
In addition, if the rate hike is too strong and consumption falls too much, there is a possibility that economic activity will decline and enter a recession that will lead to the destruction of jobs, as the president of the Federal Reserve, Jerome Powell. “We have to be careful, because we can go into a recession and slow down,” says Montserrat Guillén, professor of economics at the UB. “Surgery needs to be done,” Pons adds on the role of central banks. A scenario with a stagnant economy and soaring prices is called stagflationa real danger according to institutions such as the World Bank.
In addition, Pons recalls that there is a part of inflation that already existed before the war in Ukraine. “The pandemic has changed people’s behavior,” says Pons, a fact that is especially noticeable in consumption and is increasing demand. In this sense, the economist believes that inflation also has its origin in a certain “overheating” of demand caused by high household spending that was the result of savings accumulated during the pandemic. Pons hopes that this effect will be diluted from the autumn, when the holidays are over and families will be able to contain their expenses again.
“Rate increases must be accompanied by fiscal policies so that they affect less those who can suffer the most” ”
Ernest Pons Professor of Economics at the UB
Companies, on the other hand, will also have more difficulty accessing credit, and this makes it difficult for them to invest. The rate hike, then, “can slow down business projects,” Guillén warns. In addition, a significant proportion of companies are in debt, so the costs of debt will also grow.
The mortgagors, the first victims
“The most immediate effect will be on people who have mortgages” at a variable rate, Guillén points out. However, the UB professor draws iron in the case of young families who still have years of payments ahead of them: “Banks always renegotiate,” she recalls, so it is common that if the monthly mortgage installments they go up too much, the loan can be extended or the conditions can be changed, with the same entity or with a new one.
“We have to be careful with rate hikes because we can go into a recession and go braking.”
Montserrat Guillén Professor of Economics at the UB
Pons also points to the risk that inflation will not fall so quickly and that in the end it will end up in wage increases, with the danger of entering an inflationary spiral: higher prices force wages to rise, wages rise to increase demand, which further inflates prices.