Pēteris Strautiņš October 25, 2023 6:50 a.m
During the past two years, the people of Latvia have experienced both the highest inflation in almost thirty years and unusually high interest rates against the background of the previous decade. These events were related – the European Central Bank raised rates to reduce inflation. Now we can already say that inflation has normalized, it decreased from 22.5% a year ago to 3.3% in September this year, there is no doubt that it will be even lower in October. Does this mean that interest rates will also come down?
The simplest answer would be to see what the financial markets say. Forecasts priced in financial instruments say that the probability of another rate hike is small, around 10%. On the other hand, the probability that the rates will decrease in March is now twice as high, after that the probability of a rate decrease increases every month, until next September one or two standard steps of rate decrease (0.25 percentage points) could have been taken. Markets also think that these steps will not be many, in the longer term rates could decrease to around 3%.
Financial market experts are smart people, but they are not infallible. It is especially important now to take into account not only the events in the world of numbers, but also to try to understand how the rational world of money will be affected by the storms of human emotions in the Middle East and elsewhere. Nor should we forget history. Central banks usually and currently plan for downward phases of rates to be like flat slopes. However, experience shows that these curves often look like steep walls in graphs.
It is indeed very likely that the rate cut will begin gradually. But in the second half of next year, it may move into an acceleration phase. Why?
The tragic events in Israel and the Gaza Strip have slightly increased the risks of inflation in the near term. As a result of these events, oil prices have increased by about a tenth. Fuel prices that directly affect the population of Latvia are relatively more favorable, the price of gasoline on the stock exchanges is still close to the lowest levels of the year, but risks exist. These events are also bad news for economic growth – the scary news background affects consumer sentiment and businessmen’s willingness to invest. However, this is good news for inflation fighters, because the historically low unemployment rate in the eurozone, alongside the 2021-2022 echoes of the annual rise in raw material prices, is an inflation-enhancing factor. Economists’ forecasts for eurozone growth next year have been sliding downward for several months. The rapid deterioration of the indicators reflecting the future of construction in Europe – building permits, construction starts – suggests that downward forecasts will follow reality for a long time to come.
The European Central Bank (ECB) has an excellent team of macro experts, but decisions on pricing in companies are sometimes better understood by people who see the processes in the business world on a daily basis and can also react more quickly to what is happening. Euribor rate hikes in the face of falling inflation are largely justified by monetary policy makers that core inflation (or inflation that excludes some of the more volatile components) remains at a high level. Already in February wrote, that this indicator has partially lost its applicability, the behavior of price-forming factors has been so unusual. It could have been expected to decline sharply when a year passed since the sharp rise in production costs last year, when gas and electricity prices in Europe soared. September was when this effect should have become visible, and core eurozone inflation actually fell from 5.3% to 4.5%. Manufacturers don’t want to pass on the benefits of falling costs to consumers, but the calendar is unstoppable. The latest data also shows the biggest drop in producer prices in Germany since the index began to be calculated in the 1940s, and Chinese export prices are falling. Sometimes the economy changes faster than international financial institutions can keep up with.
In summary, monetary policy makers will have both the opportunity to reduce interest rates – inflation will continue to decline, and the necessity – growth will weaken, very likely to the negative territory. In addition, let’s keep in mind that there may be another player involved in the battle of the forces pulling the rates up and down. The specter of fiscal dominance hovers over global financial markets. Investors are increasingly counting on the possibility that central banks will have to mitigate the risks of governments losing access to financial markets. The ECB is already trying to mitigate the so-called fragmentation risks of the eurozone through asset purchases, but these options are not unlimited.
The past two years have been a financially difficult time for households. In the period between January 2022 and April 2023, real wages decreased, previously they had grown continuously for more than 10 years. In addition, since the end of last year, a part of the population is significantly feeling the impact of the increase in interest rates. It can be said with great confidence that the top of this mountain of difficulties will be overcome next year.
The author is Luminor chief economist of the bank
2023-10-25 03:53:19
#Euribor #decrease #IR.lv
