Will there be a recession in Europe?

On Thursday July 21, the European Central Bank announced that its interest rates had been raised by 0.5%. In this way, the fundamental interest rate went 0% to 0.5%. The markets were expecting a rise of 0% to 0.25% and it was higher.

The announcement indicates that there will be further hikes for the next meeting (September 8), if inflation has not improved by then. The ECB’s objective is for inflation in the euro zone to be around 2%. In June, it was 8.6% and it is impossible for it to change in two months. Interest rates will rise again in September.

Why did the ECB raise its rates?

The reasons for this decision are multiple and the main one is the growth of inflation in recent months. Initially, inflation in the Eurozone was attributed to the effects of the Russian invasion of Ukraine on fuel and food prices (underlying inflation). But now all the prices are going up.

According to Eurostat, in June inflation without fuel or food was 3.7%. The European Central Bank could not wait any longer to raise interest rates.

The second reason is that the euro zone is lagging behind the United States. On Wednesday July 27, the United States raised the Federal funds rate (and there have been four increases since March) putting it in a range of between 2.25% and 2.50%.

The main consequence of the difference in rates for Europe is the appreciation of the dollar against the euro. In Europe, fuels and a large part of imported goods are bought in dollars, so with a more expensive dollar, the European bill for oil, gas and other goods increases and this drives up inflation. Moreover, the fact that the United States offers a higher interest rate encourages investors around the world to decide to invest more in the United States and less in the countries of the euro zone.

Why did the ECB delay taking this decision?

On the one hand, because by increasing the interest rate, the debt of the States of the euro zone becomes more expensive. Savers demand more profitability to buy German, Spanish, Italian, etc. public debt securities. But savers do not have the same confidence in Italian or Spanish public debt as in Germany. Therefore, they charge a higher rate of interest to buy Italian and Spanish; this is the risk premium.

If the risk premium increases a lot, the Treasury of the corresponding country has difficulty financing itself. For this reason, the recently announced interest rate hike is accompanied by a transmission protection instrument (ITP) which allows the ECB buy the debt of only one specific country and not at all, as so far. The objective is to prevent this country’s risk premium from increasing too much and it becoming very costly for it to finance itself. This is why the two decisions were launched at the same time and were announced at the same time.

The other reason is that the rise in interest rates can strongly reduce the growth of the euro zone economy. By raising rates, businesses invest less and households take out fewer mortgages and buy fewer cars and other assets on credit. Plus, it increases what you have to pay each month for a variable interest rate loan. This affects demand, production and ultimately GDP.

forecasts

According to the latest estimate, in the United States GDP fell by 0.9% in the second quarter of 2022. In the first quarter, the decline was 1.6%. Two consecutive quarters of declining GDP are technically considered a entry into recession.

What can happen in the euro zone? In his paper on macroeconomic outlook In June, the ECB assumed that growth in 2022 would be 2.8%, but in the same document three months earlier it predicted growth of 3.7%. As a result, expectations deteriorate.

Whether Europe is headed for a recession remains to be seen. Its average growth figure is below 1%, in a year it was expected to recover from the effects of the pandemic. Thus, the braking is considerable. And that will affect 2023, because the forecast for that year in the June report is 2.1% growth, while in March it was 2.8%.

If the European Central Bank raises rates further in September to fight inflation, the effect could be even more negative. The final factor, and the most difficult to predict, is the duration of the Russian invasion of Ukraine. The longer it lasts, the worse the effects will be for the economies of the euro zone. The economies of other large areas, such as the United States, China, India or Latin America, will suffer less effects. The greatest impact of the war, outside of the countries in conflict, is in Europe.

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