ECB's Hesitant Policies Fuel Inflation

BERLIN (Reuters) – The European Central Bank (ECB) has exacerbated inflation in the monetary union with overly cautious policy, according to a study by the German Institute for Economic Research (DIW).

The study, seen exclusively by Reuters, claims that had the ECB increased key interest rates gradually starting in mid-2021, inflation would have peaked at a maximum of 3% instead of exceeding 10% in August 2022.

With rising inflation from mid-2021 and a significant spike following the Russian invasion of Ukraine in February 2022, the central bank initially refrained from raising interest rates, only ending its zero interest rate policy in July 2022.

Ben Schumann, the study's author, stated, "One of the reasons given by the ECB for its hesitant response was that its monetary policy could not influence energy prices. But this assumption is wrong. It could have tackled the last wave of inflation directly at its roots."

The study contends that monetary policy influences energy prices on the global market since higher key interest rates would reduce energy demand within the eurozone. Additionally, if interest rates had been raised sooner, the euro would have appreciated against the dollar, thereby reducing energy prices typically settled in USD.

Although many ECB policymakers admitted that earlier rate hikes could have been beneficial, they argue the bank quickly adjusted through several significant increases, including several 75 basis point hikes in autumn 2022. The ECB began hiking from -0.5% only in July 2022, after many global peers had already raised rates. The consecutive 10 hikes have since brought the deposit rate to a record high of 4% by summer 2023.

Schumann remarked, "By raising interest rates, the ECB would also have made a clearer commitment to fighting inflation, reducing inflationary pressures such that it wouldn’t have spiked as severely following the Russian invasion."

Eurozone inflation peaked above 10%, among the highest in developed economies, though the U.S. and UK also saw significant surges (9.1% and 9.6%, respectively). However, analysts suggest Europe's dependence on imported energy was the main driver of price increases.

The DIW posits that the ECB's reluctance stemmed from poor economic conditions in many eurozone countries post-COVID and concerns for financial sector stability.

Overall, if key interest rates had been raised earlier, it is estimated that the eurozone's GDP would have been about 3% lower initially, but would have recovered by the end of 2023.