Why is it that ordinary people sometimes find it so hard to understand economics? Well, consider the following gobbledegook – sorry, statement – from European Central Bank Chief Economist Philip Lane, published in the Irish Times yesterday, explaining why interest rates will continue to rise:
“By bringing the key policy rates to a sufficiently restrictive level and fostering a period of below-trend growth through the dampening of demand, we will counteract above-target medium-term inflation pressures and also ensure that the prolonged phase of above-target inflation does not become embedded through a de-anchoring of inflation expectations,” Mr Lane said.”
Let’s translate that:
“Bringing the policy rates to a sufficiently restrictive level”
The thing that they wish to restrict here is borrowing. In simple terms, every increase in the ECB’s interest rates pushes up the potential repayments on a loan that someone might wish to take out. Those readers who have taken out a mortgage in the past decade or so will be familiar with the “stress testing” that banks do on potential customers ahead of offering them loans. In this process, they test your ability to repay in a number of simulated scenarios: The loss of one income. An increase in interest rates. An economic shock. And so on, and so on.
The bottom line here is that if the baseline interest rate is higher, more people will fail those stress tests, and will have to borrow less, or not at all. As such, less money will be lent out by banks.
That is the ECB’s objective. Which leads us to:
“fostering a period of below-trend growth through the dampening of demand”
If you are a regular reader of my pieces on economics, then you will be familiar with this phrase: The only known solution to inflation is recession.
What is recession? It is defined as two quarters, or half a year, of “negative growth”. Negative growth is when the total value of the money in circulation in an economy falls.
When the total amount of money falls, then many people have less of it than they had before. This means that they can buy fewer things. Which means that “demand” is dampened. You cannot buy new goods, so demand for those goods falls.
And when demand falls, the price usually falls with it. This is called “deflation” and is the opposite of inflation.
So what the ECB Chief Economist is saying here, in layman’s terms, is that to solve inflation, you must have less money in your pocket.
And, by the way: He’s right. It’s just it’s the kind of thing you can’t say outright, because there would be war. So instead, economists are well trained to speak in inaccessible gobbledegook.
“we will counteract above-target medium-term inflation pressures and also ensure that the prolonged phase of above-target inflation does not become embedded through a de-anchoring of inflation expectations”
I’ll be honest: This one is so impenetrable that Sir Humphrey would be proud of it, and I had to read it several times myself to make head or tail of it.
In essence, what he is saying is as follows:
The longer inflation lasts, the more people begin to price inflation into their decisions. For example, imagine you are a landlord renting out a property to a new tenant for a three year contract. Where do you set the rent, in an era of rent controls? If inflation continues on its current pace, then each €1000 per month might only have the buying power of €750 per month in two or three years. Therefore, if you can get away with it, you’ll try and set a rent that you’d be happy to take in two or three years time.
Because people think prices will rise, they will raise their prices, in other words.
By contrast, if people think prices may begin to fall, it can become a self-fulfilling prophecy. You begin to lower your prices in order to gain more market share, because you do not fear getting caught out by higher fuel, and supply, and storage costs. It also might give you, as an employer, leverage in wage negotiations.
If people expect costs to rise, they demand their wages to rise with it. Creating a negative growth environment – even a recession – might also reduce expectations of wage rises.
In short, the ECB’s plan is to nudge the economy in the direction of a recession, in order to combat inflation.
This is the correct plan, even if it would be desperately unpopular if said out straight. There is nothing our politicians can do about it, since the ECB is an independent body outside of their control. We all have to live with it, and hope it works out.
But, if you’re on a mortgage, now might be a good time to consider how best to react to rising interest rates. Because they’re coming for a while yet.
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