ECB Takes Decisive Action: Raises Interest Rates to Tackle Prolonged High Inflation and Assessing Economic Activity

May 22, 2023

The inflation outlook continues to be too high for too long. In light of the ongoing high inflation pressures, the Governing Council decided at its meeting on 4 May 2023 to raise the three key ECB interest rates by 25 basis points. Overall, the incoming information broadly supports the assessment of the medium-term inflation outlook that the Governing Council formed at its previous monetary policy meeting on 16 March. Headline inflation has declined over recent months, but underlying price pressures remain strong. At the same time, the past rate increases are being transmitted forcefully to euro area financing and monetary conditions, while the lags and strength of transmission to the real economy remain uncertain.

The Governing Council’s future decisions will ensure that the policy rates will be brought to levels sufficiently restrictive to achieve a timely return of inflation to its 2% medium-term target and will be kept at those levels for as long as necessary. The Governing Council will continue to follow a data-dependent approach to determining the appropriate level and duration of restriction. In particular, the policy rate decisions will continue to be based on the Governing Council’s assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation, and the strength of monetary policy transmission.

The key ECB interest rates remain the Governing Council’s primary tool for setting the monetary policy stance. In parallel, the Governing Council will keep reducing the Eurosystem’s asset purchase programme (APP) portfolio at a measured and predictable pace. In line with these principles, the Governing Council expects to discontinue the reinvestments under the APP as of July 2023.

Economic activity

Global economic activity was stronger than expected in early 2023. The global economy was supported by China’s economic reopening after the end of its zero-COVID policy, along with resilience in the US labour market – significant monetary policy tightening notwithstanding. Trade, however, remained relatively weak as the recovery in activity was concentrated in less trade-intensive demand components, such as services. Global headline inflation continues to recede, while core inflation remains at elevated levels.

The euro area economy grew by 0.1% in the first quarter of 2023, according to Eurostat’s preliminary flash estimate. Lower energy prices, the easing of supply bottlenecks and fiscal policy support for firms and households have contributed to the resilience of the economy. At the same time, private domestic demand, especially consumption, is likely to have remained weak.

Business and consumer confidence have recovered steadily in recent months but remain weaker than before Russia’s unjustified war against Ukraine and its people. The Governing Council sees a divergence across sectors of the economy. The manufacturing sector is working through a backlog of orders, but its prospects are worsening. The services sector is growing more strongly, especially owing to the reopening of the economy.

Household incomes are benefiting from the strength of the labour market, with the unemployment rate falling to a new historical low of 6.5% in March. Employment has continued to grow and total hours worked exceed pre-pandemic levels. At the same time, the average number of hours worked remains somewhat below its pre-pandemic level and its recovery has stalled since mid-2022.

As the energy crisis fades, governments should roll back the related support measures promptly and in a concerted manner to avoid driving up medium-term inflationary pressures, which would call for a stronger monetary policy response. Fiscal policies should be oriented towards making the euro area economy more productive and gradually bringing down high public debt. Policies to enhance the euro area’s supply capacity, especially in the energy sector, can also help reduce price pressures in the medium term. In this regard, the Governing Council welcomes the publication of the European Commission’s legislative proposals for the reform of the EU’s economic governance framework, which should be concluded soon.

Inflation

According to Eurostat’s flash estimate, inflation was 7.0% in April, after having dropped from 8.5% in February to 6.9% in March. While base effects led to some increase in energy price inflation, from -0.9% in March to 2.5% in April, the rate stands far below those recorded after the start of Russia’s war against Ukraine. Food price inflation remains elevated, however, standing at 13.6% in April, after 15.5% in March.

Price pressures remain strong. Inflation excluding energy and food was 5.6% in April, having edged down slightly compared with March to return to its February level. Non-energy industrial goods inflation fell to 6.2% in April, from 6.6% in March, when it declined for the first time in several months. But services inflation increased to 5.2% in April, from 5.1% in March. Inflation is still being pushed up by the gradual pass-through of past energy cost increases and supply bottlenecks. In services, especially, it is still being pushed higher also by pent-up demand from the reopening of the economy and by rising wages. The information available up to March suggests that indicators of underlying inflation remain high.

Wage pressures have strengthened further as employees, in a context of a robust labour market, recoup some of the purchasing power they have lost as a result of high inflation. Moreover, in some sectors firms have been able to increase their profit margins on the back of mismatches between supply and demand and the uncertainty created by high and volatile inflation. Although most measures of longer-term inflation expectations currently stand at around 2%, some indicators have edged up and warrant continued monitoring.

Source: European Central Bank (ECB)
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