In late 2021, central banks around the world began unwinding liberal monetary policy stances and taking the first steps towards quantitative tightening in a bid to fight record inflation. The European Central Bank started raising interest rates in July 2022 at an almost unheard of speed and scale, culminating in a rise of about 300 basis points (to 2.5%) by February 2023.
The rate hikes were expected to help curtail increasingly dangerous inflation rates. However, with nearly a year of interest rate increases behind us, it’s potentially time to ask (although perhaps prematurely): have the interest rate hikes had the desired effect?
In my opinion, the recent rise in interest rates in European countries has started to show its effects on their economies. At least in the EU area, slightly declining inflation levels have been recorded, providing some justification for elevating interest rates in the region. However, are there other, perhaps unsavory effects of interest rate hikes?
The general impact of interest rate hikes
One immediate effect of raising interest rates is the impact on borrowing and lending. As interest rates rise, borrowing becomes more expensive, which can discourage individuals and businesses from taking out loans. This can slow down economic activity, as businesses may delay investments and individuals may postpone large purchases.
On the other hand, higher interest rates can also encourage saving, as deposit rates also increase. This could be beneficial for those saving for retirement or other long-term goals. Higher savings could lead to more investment in the economy, which could in turn lead to more economic growth.
Another impact of rising interest rates is on the stock market. When interest rates rise, it becomes more expensive for companies to borrow money for expansion or other purposes. This can lead to a decrease in the value of stocks, as investors may see less potential for growth and may sell off their holdings. For instance, European stock markets closed lower on the news of further rate hikes in March 2023, highlighting the inverse relationship the market can often have with interest rates.
However, a rise in interest rates can also signal to investors that the central bank is taking measures to control inflation, which can boost confidence in the economy. This could lead to increased investment and a rise in the stock market over the long-term. Unfortunately, the market has taken a mostly wary stance toward rate hikes, with many analysts suggesting that if the rate increases are not properly managed the economy could fall into depression.
The recent effects in Europe
In Europe, countries such as the UK have recently maintained interest rate hikes to combat inflation. The UK raised its interest rate to 4.25%, its highest level in decades. Yet, inflation remains in double digits in the UK, including a recent rise from 10.1% to 10.4% after three consecutive months of decline.
The immediate effects of these rate hikes have been mixed. In the UK, some businesses have reported a slowdown in sales, as consumers have become more cautious about spending. However, others have reported increased savings and investment, which could boost economic growth in the long-term. The general consensus is that inflation has remained hard to tackle, and in the estimation of one market observer: “It’s now clear the UK has an inflation problem that is worse and more persistent than in Europe and the US. Price rises here are proving more difficult to neutralise and the Bank of England will almost certainly add at least one more quarter-point hike to borrowing costs.”
The European Central Bank itself estimates that the rate hikes caused a 0.2% fall in inflation rates during 2022. However, the agency projects that the core results of the monetary tightening will not materialize until 2023 and beyond. They are still bullish on the efficacy of rate hikes in fighting inflation and project that inflation rates will fall by around 1.2% in 2023 and 1.8% in 2024.
However, the ECB is quick to note that it’s important to account for other factors that could be shaping the narrative, “including interactions with other domestic and global shocks potentially shaping macroeconomic dynamics.”
Overall, it seems that the effects of rising interest rates in Europe continue to depend on a variety of factors, including the strength of the economy, the level of inflation, and the actions of the central bank. While higher interest rates may lead to slower economic growth in the short-term, they could also lead to increased savings and investment, which could boost the economy in the long-term.
In conclusion, the recent rise in interest rates in Europe has started to show its effects on the economy. While the immediate impact has been mixed, it is clear that higher interest rates can have both positive and negative effects on borrowing and lending, the stock market, and the overall economy. It will be important for policymakers to carefully consider the impact of interest rate hikes and to take steps to mitigate any negative effects, while also working to control inflation and ensure long-term economic growth.