The main aim of a central bank is the maintenance of price stability. The European Central Bank (ECB) considers that price stability is best maintained by aiming for a two per cent inflation target over the medium term. To this effect, the Governing Council of the ECB meets regularly to set its official interest rates.
The latter influences the interest rates which banks in turn offer to their customers. The long period of exceptionally low official interest rates has enabled banks to offer loans at more affordable rates, but also resulted in less attractive interest rates on deposits.
A high inflationary environment normally leads to an increase in official interest rates. Economic theory suggests that higher interest rates would limit the overall expenditure in the economy, thus creating a cooling effect on prices.
This explains the decision by the US Federal Reserve to raise its interest rates in March. On the other hand, the ECB has so far maintained its interest rates unchanged at historically low levels, despite the inflation rate in the euro area reaching historically high levels.
Monetary policy decisions impact the economy with a lag, normally exceeding one year. To address this problem, central banks base their decisions on future price developments. Hence, what matters is not the current but rather the expected inflation rate.
Another factor to consider is the so-called Brainard Principle, which states that policy should exhibit conservatism in the face of uncertainty. This is particularly relevant as there is considerable uncertainty with regard to the medium-term inflation rate outlook in the euro area.
The ECB’s current baseline forecasts anticipate that euro area inflation will be high this year, but it is then expected to stabilise in the region of two per cent in 2023 and 2024. Like any forecast, this scenario is based on technical assumptions. A key assumption is that the inflationary expectations remain anchored around the ECB’s two per cent target.
The ECB’s baseline forecasts anticipate that euro area inflation will be high this year- Malcolm Bray
Expectations play a central role in economics, particularly as these often turn into self-fulfilling prophecies. However, the longer euro area inflation stays significantly above two per cent, the less plausible such assumption will appear. The incoming inflation data will thus be a key variable that the ECB will be monitoring over the next months, to verify the extent to which there is risk that the high inflation environment persists.
As ECB vice-president Luis de Guindos said in a recent interview, “our decisions are based on the data. Second-round effects and a potential de-anchoring of medium-term inflation expectations will be the deciding factors.”
The last time the ECB raised its interest rates was more than 10 years ago, in 2011. At the current juncture, one cannot exclude the return of interest rate increases by the ECB over the next months. Indeed, according to the March 2022 ECB Survey of Monetary Analysts, the median expectations by professional forecasters for a possible rate increase is December 2022.
At the same time, to address possible concerns, particularly at a time when Europe is hit by the adverse economic effects of the war in Ukraine and the sanctions against Russia, ECB President Christine Lagarde stated that “future adjustments to rates, when they come, will be gradual”.
The current financing conditions for businesses in Malta remain attractive. Data published by the Central Bank of Malta shows that in January 2022, the weighted average interest rate on outstanding loans to businesses in Malta was almost 300 basis points lower than when Malta adopted the euro, in January 2008.
Apart from the ECB’s accommodative monetary policy, the various risk sharing instruments provided by the European Investment Bank, as well as by the Malta Development Bank, also permit Maltese banks to offer attractive conditions on some of their loans.
These include interest rate subsidies and less onerous collateral requirements. Since such schemes normally have a time limit and an overall envelope amount, it is in the interest of businesses to explore how they can tap into such opportunities.
Malcolm Bray is a market intelligence specialist at Bank of Valletta.
The author and Bank of Valletta have obtained the information contained in this article from sources they believe to be reliable, but they have not independently verified the information contained herein and therefore its accuracy cannot be guaranteed.
The author and the bank make no guarantees, representations or warranties and accept no responsibility or liability as to the accuracy or completeness of the information contained in this article. The author and bank have no obligation to update, modify or amend the article, or to otherwise notify readers thereof in the event that any matter stated therein, or any opinion, projection, forecast or estimate set for the herein changes or subsequently becomes inaccurate.
Bank of Valletta plc is a public limited company regulated by the MFSA and is licensed to carry out the business of banking in terms of the Banking Act (Cap. 371 of the Laws of Malta).