The European Central Bank (ECB) has increased its base interest rates ten times before announcing a pause. During the October meeting, the Governing Council of this financial institution, which met in Athens, decided to halt the record-fast cycle of interest rate hikes. For many borrowers, the most pressing question is, “When will the reduction begin?” However, it is also worth considering the question of quantitative tightening. This decision could effectively curb inflation and foster sustainable economic growth.
Why did the ECB decide not to increase interest rates this time? They were raised from -0.5%-0.25% to the current 4.00%-4.75% range in just over a year. There has never been such a rapid increase in the euro area’s history. This policy has reduced inflation from 10.6% to 4.3 % within a year. The increased rates are expected to “make substantial contribution” ensuring that inflation approaches the 2% target, as projected by the ECB.
The slowing of inflation can also be expected because the normalization of monetary policy is already causing a reduction in the amount of money in circulation. The expansion of the money supply in the euro area during the pandemic led to a general rise in prices.
Now, the narrowest measure of the money supply (M1), covering cash and overnight deposits, has decreased by 10 per cent over the year (from 11.8 trillion euros to 10.5 trillion euros) and returned to its early 2021 level. Therefore, the reverse process – removing money from circulation – should help suppress inflation.
No News on Quantitative Tightening
The ECB achieved such rapid growth in the money supply during the pandemic not because of negative interest rates but because of its quantitative easing policy. In early 2020, the Pandemic Emergency Purchase Program (PEPP) was initiated, which envisaged the purchase of securities for 1.85 trillion euros. The purchase of bonds under this program was stopped in March 2022, but reinvestment continued. The replacement of bonds up to the end of 2024 was continuously planned. This decision ensures that the money injected into the economy during the pandemic continues circulating.
However, there were rumours before the October meeting of the Governing Council that discussions about reviewing the ECB’s securities portfolio could take place in Athens. Some central bank representatives mentioned the possibility of an earlier halt to PEPP reinvestment. Such a decision would contribute to a more rapid reduction in the money supply, further suppressing inflation.
Unfortunately, these rumours did not materialize. ECB President Christine Lagarde stated that this issue was not discussed at the recent meeting. Therefore, ECB will continue to combat rising prices solely by using high interest rates.
Although the ECB has not yet decided to engage in more rapid quantitative tightening, the public discussion of this kind raises hope that the pandemic’s lessons have been learned. The discussions about quantitative tightening acknowledge that the artificial pouring of money into the economy over the past decade does not lead to sustainable growth but only enables the depreciation of money.
It is considered that within 4-5 years, the ECB could restore its portfolio to the level before 2007, when the purchase of securities was not yet being executed. A consistent end to the policy of cheap money can be achieved not only by raising interest rates, but also by renouncing quantitative stimulus. This strategy would keep inflation from reaching record highs in the future.
Written by Leonardas Marcinkevičius – an expert at Lithuanian Free Market Institute.