Ülo Kaasik: Interest rates had to be raised to curb euro area inflation

Assessing recent developments, it is understandable why financial markets expect additional interest rate hikes from the European Central Bank to ensure inflation returns to the two percent target within a couple of years, Ülo Kaasik writes.

The conflict in the Middle East, ongoing for more than half a year, continues. It puts pressure on energy prices and affects overall inflation in the euro area. To bring inflation back toward the two percent target, the ECB Governing Council decided to raise interest rates by 0.25 percentage points. The rate with the biggest impact on financial markets is the deposit facility rate, which will rise to 2.5 percent.

Euro area inflation accelerated to 3.3 percent in August due to higher energy prices (2.9 percent in July). Even faster price growth has recently been held back by food prices rising more slowly than expected.

At the same time, recent developments in energy markets indicate a significant risk that inflation could accelerate further. Oil has climbed to one hundred dollars per barrel, and gas prices in Europe are even more concerning. Gas has risen nearly two and a half times compared with a year ago, from €33 to €80 per megawatt-hour. Fuel prices at filling stations remain under pressure from high oil refining margins.

It is worth remembering that gas prices are still much lower than in 2021 and 2022, when they peaked at around €340 per megawatt-hour in August 2022.

Although slower food price growth has offered some relief amid rapid overall inflation, this may prove temporary. The risk of faster food price inflation has not disappeared. Contributing factors may include rising global grain prices, weather changes caused by the El Niño climate pattern, and the pass‑through of higher energy and fertilizer costs into food prices.

Despite the difficult environment, the euro area economy has shown strong resilience. Second‑quarter economic growth of 1.2 percent compared with the same period last year can be considered a very good result. Ireland's GDP continues to cause significant quarterly fluctuations, but overall growth has been fairly broad‑based. Consumption and exports have remained strong, and growth has been supported by increased government spending.

Several indicators — including confidence and loan growth — suggest that a solid growth pace could continue. Third‑quarter data may show some setbacks, however, because this summer's heatwave disrupted transport on the Rhine River, forced reductions in electricity production due to a lack of cooling water, and damaged agricultural output.

In September, the ECB also updated its economic forecast for the coming years. Given the high uncertainty, it is reasonable to rely on several scenarios, and that is what was done this time.

Based on assumptions set in mid‑August, inflation is expected to accelerate somewhat in the near term. Markets expect the impact of the conflict to ease next year, which could help bring inflation back near the two percent target.

Risks remain high, and inflation may turn out faster than projected in the baseline scenario. Recent developments in energy markets point to the possibility that gas and fuel prices will rise more than expected and stay elevated longer.

Despite the energy price shock, the forecast expects euro area economic growth to continue: 1.4 percent in 2027 and 1.5 percent in 2028. This is good news for Estonia, as our economic outlook depends heavily on the growth of our main trading partners.

Considering recent developments, it is understandable why financial markets expect additional interest rate hikes from the ECB to ensure inflation returns to the two percent target within a couple of years.

The situation remains extremely uncertain. It is very difficult to predict what the economic environment will look like in the coming months and what decisions the ECB Governing Council will need to make at upcoming meetings.

In addition to short‑term interest rates, long‑term government bond yields have risen rapidly, reflecting market concerns about fast‑growing debt. This has been amplified by the increased volume of bonds issued to finance artificial intelligence investments. This directly affects Estonia as well, since the loan taken to cover the large budget deficit will require paying higher interest.

The comment was first published on Eesti Pank's blog .

Follow ERR News on Facebook and X and never miss an update!