Inflation rises, European Central Bank faces triple dilemma

Central banks around the world are grappling with the difficult task of managing excessive inflation while keeping their economies afloat.

In recent years, the European Union (EU) central bank has faced a triple dilemma, requiring delicate balancing actions and strategic decisions as persistently high inflation threatens to paralyze the economy.

Triple Dilemma

Carsten Brzeski, global head of macro at ING Bank in the Netherlands, succinctly summarized the recent challenges faced by the European Central Bank:

“All central banks are grappling with the same triple dilemma: how to balance a slowing economy, inflation that remains too high, and the delayed impact of unprecedented interest rate hikes.”

Another common trend among ECBs is that they are close to peak interest rates. This proximity complicates the above dilemma. When interest rates are already near their peak, central banks have less room to maneuver in response to changing economic conditions.

This limited flexibility means central banks must be more cautious in their monetary policy decisions. The recent surge in oil prices has added to the complexity of the situation. Rising oil prices have a dual impact on the economy.

On the one hand, they can exacerbate inflationary pressures by increasing energy costs, which can ripple through all sectors of the economy. On the other hand, higher oil prices may increase production costs and reduce consumers’ spending power, thereby dragging down economic growth.

This problem puts central banks in a difficult position. They must carefully assess the possible inflationary impact of rising oil costs, as well as the negative impact on economic growth. Deciding whether to tighten or loosen monetary policy in response to oil price swings requires a complex balancing act.

With the exception of the EU, central banks respond to uncertainty

Central banks around the world are grappling with the difficult task of managing excessive inflation while keeping their economies afloat. For example, the Bank of England recently chose to suspend interest rate increases after 14 consecutive rate hikes, with the main policy rate stable at 5.25%.

The decision was a close call, with five members of the Monetary Policy Committee voting to remain unchanged and four members in favor of raising interest rates by 25 basis points. Lower-than-expected inflation data for August (6.7% year-on-year) may have influenced this decision. While still above the Bank of England’s 2% target, it was below the 7% forecast.

In Switzerland, the Swiss National Bank opted to pause for the first time since March 2022, citing sharp tightening of monetary policy in recent quarters to combat remaining inflationary pressures. Swiss inflation was 1.6% in August, within the national target range of 0-2%.

Swiss National Bank President Thomas Jordan stressed that “the war against inflation is not over yet,” suggesting further policy tightening is possible in December. The SNB forecasts that annual Swiss inflation will average 2.2% in 2023 and 2024 and 1.9% in 2025, assuming the policy interest rate remains at 1.75%.

On September 14, the European Central Bank increased interest rates by 25 basis points, which means that interest rates have reached their peak. The ECB noted that maintaining these interest rates would go a long way toward returning inflation to target levels in a timely manner. However, the bank did emphasize that interest rates will remain at appropriately restrictive levels for as long as necessary.