Background:
European inflation is driven by energy (intensity). Inflation falls as energy prices drop.
Credit Suisse profile
HSBC profile
Transcript with links to sources:
The European Central Bank is raising interest rates.
Here is ECB President Lagarde:
“The Governing Council decided today to raise the three key ECB interest rates by 75 basis points. […] The Governing Council also decided to change the terms and conditions of the third series of targeted long-term refinancing operations, known as TLTRO III.” (press release, video)
In this video, I’ll explain what it all means.
Why is the ECB raising interest rates?
The ECB is responsible for price stability in the euro area. It defines price stability as an annual inflation of two percent. But since the summer of 2021, inflation has exploded far above the two percent target. In September of 2022, inflation was 9.9 percent.
So what is the ECB doing about inflation?
The ECB has raised two1 key interest rates.
The ECB pays the deposit facility rate on money that banks have deposited at the ECB. That’s similar to the interest rate you receive on your savings account.
Banks can also borrow money from the ECB for a short period. These seven day loans are called “main refinancing operations” (MRO). The main refinancing operations rate is the interest rate that the ECB receives on these loans.
The ECB has increased the deposit facility rate and the main refinancing operations rate already three times in 2022.
Before these rate hikes, the deposit facility rate had been negative since 2014. And for previous rate hikes, we even have to go back to the year 2011. As of 2 November 2022, the deposit facility rate will be 1.5 percent and the main refinancing operations rate will be 2 percent.
How much money will the ECB pay to banks or receive from banks?
To answer that question, we need to look at the balance sheet of the ECB. The ECB has a balance sheet of almost 8.8 trillion euro (8,800 billion euro).
At 4.6 trillion euro, the deposits of banks in the deposit facility make up a little more than half of the ECB’s liabilities.
I didn’t forget to include the main refinancing operations, but these loans are less than 4 billion euro, so you cannot see them on the asset side of the balance sheet.
How much will the ECB pay to banks?
4.6 trillion deposits times a deposit facility rate of 1.5 percent means that the ECB will pay 69 billion euro to banks. The ECB will actually pay a little more, because banks also have something called “minimum reserves” at the ECB. And by the end of 2022, the ECB will also pay the deposit facility rate on these minimum reserves. Before [21 December 2022], it paid the main refinancing operations rate.
Lagarde: “The Governing Council also decided to change the terms and conditions of the third series of targeted long-term refinancing operations known as TLTRO III.”
So TLTRO III are three-year loans made by the ECB to commercial banks. The ECB offered these loans between the end of 2019 and the end of 2021. What was special about these three-year loans is that banks had to pay a negative interest rate to the ECB. So in fact they could borrow money from the ECB and pay back less than they had borrowed in the first place.
You can ask “why did the ECB do that?” Well, if you look at the inflation chart, you can see that at the time when the TLTRO loans were initiated, inflation was below the two percent target of the ECB. But now that inflation is far above the two percent target, the ECB has decided that these negative rates on the TLTRO loans are no longer justified.
And so they have decided to increase the interest rate for the remainder of the TLTRO period to the deposit facility rate. For banks that have outstanding TLTRO loans and also deposits in the deposit facility, the ECB has made it possible to repay the TLTRO III loans early3. This will have the effect that both the assets and the liabilities of the ECB go down, so this will shrink the balance sheet of the ECB.
To recap: the ECB has increased the main refinancing operations rate to 2% and the deposit facility rate to 1.50%. The ECB will pay the deposit facility rate on the deposits and minimum reserves of banks and it will receive the deposit facility rate on the TLTRO III loans of banks.
Taking into account the interest that the ECB pays on the deposit facility and the minimum reserves, and the interest it receives from the TLTRO loans, in one year the ECB should be paying 41 billion euro to banks at the current level of the deposit facility rate (1.5%).
If you are Christine Lagarde and you want to improve your communication, I suggest you read my book Bankers are people too, in which I explain how banks and central banks work using cartoons and also a lot of balance sheets but especially lots of stories about banks and central banks.
I have focused on the technical details of higher interest rates and the TLTRO loans, but of course since the ECB is
responsible for price stability, the question is: will higher rates actually help to reduce inflation?
I did an entire video on inflation in Europe (not just in the euro area, but also in countries with other central banks than the ECB) and to be honest, it doesn’t look very promising.
So here’s a slide that shows the increase in inflation and the central bank interest rate.
And so you can see that in certain central European countries like the Czech Republic and Poland the central bank has already increased interest rates a lot more than the ECB. But you can still see that there is no correlation between the central bank interest rate and the change in inflation in European countries.
Also from that previous video, you can see what is causing the different inflation rates between countries is mostly the energy intensity of the economy. So if an economy needs more energy to produce a euro of economic output, then the inflation in that country tends to be higher. This inflation has nothing to do with deposit facilities or TLTROs.
If you want to learn more about the ECB or European banks in general, please subscribe to this channel!
Thanks for watching!
Video version here:
This post contains links to sources and some extra analyses.
After years of low inflation, inflation in Europe has gone through the roof. Germany is experiencing the highest inflation in 70 years.
In June 2021, inflation was still close to 2%. In August 2022, it was above 10% in the European Union (EU) as a whole. But that number hides a remarkable divergence between countries. In Estonia, inflation reached a stunning 25% in August 2022. In France, it was 6.6%. In Switzerland, not an EU member state, inflation was just 3.3%.
A year before, in June 2021, inflation was very close to 2% in most European countries. With 5.3%, Hungary had the highest inflation. Inflation was lowest in Portugal, at -0.6%.
In this post, we’ll look at the change of inflation in 31 countries: the 27 member states of the EU, and the United Kingdom (UK), Norway, Switzerland and Iceland.
How can we explain the dramatic, uneven rise in inflation?
Consumers are paying a lot more for energy than they used to. Companies also face higher energy bills, which has an impact on the price of their goods and services.
But energy prices are set on international markets, e.g. for oil, gas, coal and electricity. Why doesn’t expensive energy result in a similar rise of inflation across Europe?
As the following figure shows, there is a strong correlation1 between the rise of inflation and the ratio of energy use to GDP2. As a general rule, the more energy a country needs to produce a dollar of economic output, the higher its inflation. Countries in Central and Eastern Europe have higher energy intensities and higher inflation rates than their Western European neighbors.
Countries with a lower GDP per capita tend to be more energy intensive.
So it’s not surprising that Central and Eastern European countries, who are relatively poor, are experiencing higher inflation than the West3.
But it’s not just an East-West story. Even within regions with similar GDP per capita, the more energy intensive countries experience higher inflation. For example Central Europe4,
Southern Europe5,
and the Baltics6.
The picture is less clear in Western Europe. The energy intensity of Luxembourg and Ireland is distorted by the denominator (small countries with a very high GDP per capita due to the presence of international companies). France already limited energy prices in 2021. The Nordic countries are just weird ¯_(ツ)_/¯
What’s going on in Iceland? Iceland is a rich country with an abnormally high energy use. Why doesn’t this result in much higher inflation?
Although Iceland is a small nation, it’s a big producer of aluminum.
Making aluminum requires a lot of electricity. But all of Iceland’s electricity is generated from renewable sources.
So the Icelandic economy is less affected by higher fossil fuel prices than the rest of Europe. Fossil-free electricity also seems to be the explanation for the very low inflation in Switzerland.
What other factors could contribute to the rise of inflation?
According to economic theory (NAIRU, Phillips curve), when unemployment is “too low”, workers demand higher wages. And higher wages lead to higher prices.
However, there is no correlation7 between unemployment8 and the change of inflation in Europe.
Inflation rose more in Spain and Greece than it did in Germany, although the German unemployment rate is much lower.
Do deficits cause inflation (Fiscal theory of the price level)? It makes intuitive sense that if the government spends more money into the economy than it takes away with taxes, this deficit leads to inflation.
However, there is no correlation9 between government deficits10 and the rise in inflation.
Denmark and the UK have the same change in inflation, although the Danish government ran a budget surplus in 2021, while the British had an 8.1% deficit. Finland and Estonia had similar deficits, but their inflation numbers are very different.
What about public debt? Maybe inflation goes up because people lose confidence in the sustainability of the debt. Or because governments choose to inflate away the debt.
However, there is a slightly negative relation11 between government debt and inflation12.
Greece, with its massive government debt, has experienced a smaller rise in inflation than the Baltic countries, where government debt is very low. Estonia has both the lowest government debt to GDP, and the highest inflation in Europe! Inflation is higher in the Netherlands than it is in Italy, although Italy’s debt-to-GDP ratio is almost 100 percentage points higher.
Central bankers try to control inflation by changing interest rates. By influencing how expensive it is to borrow money, they influence prices of goods and services.
The picture shows central bank policy rates13 on June 1, 2022. Since that time, central banks have raised interest rates in an attempt to tamp down inflation.
But it’s not clear that interest rates have an effect on Europe’s inflation. In the euro area, where the ECB sets monetary policy for all 19 member states, inflation rose by 4.7% in France and 21.5% in Estonia.
In Slovakia, a country with a negative interest rate, the rise in inflation (+10.9%) is similar to neighboring Czech Republic (+14.6%), Hungary (+13.3%) and Poland (+10.7%), where policy rates were over 5%.
In conclusion, Europe’s worse inflation in generations is driven by energy. Conventional factors monitored by central banks don’t seem to play a role.
This work started as a small project I did during the summer, using June 2022 inflation instead of the change of inflation (see tweet below). In this post and in the video, I used the latest available data. I also added six countries (Bulgaria, Croatia, Cyprus, Malta, Romania14 and Iceland) to the dataset.
If you have any questions or suggestions about this work, you can find me on Twitter @janmusschoot or mail me at jan.musschoot@finrestra.com.
For my professional services, please contact me on Linkedin or mail me at jan.musschoot@finrestra.com.
Twitter user Rasmus checked the data points I posted in June. His test shows that the regression line slope is different from zero:
It is remarkable that there is such a strong correlation between inflation and energy intensity, given the different energy mix between countries. For example, natural gas is the most important fuel in Italy. Poland mostly burns coal, while Sweden relies on wood. While natural gas and coal prices are up hundreds of percent, that’s not the case for oil or nuclear.
I suspect the strong relation is due to electricity prices, which are often determined by the price of natural gas.
Other complicating factors that my analysis doesn’t take into account are price caps for energy (e.g. France), and the energy intensity of exporting industries (which should have less of an effect on domestic consumer price inflation).
The three Baltic countries (Estonia, Latvia and Lithuania) are outliers. Their inflation is much higher than we’d expect based on their energy intensity. It’s not obvious that the fact that they share a border with Russia is the explanation. Finland, a euro country like the Baltics, also borders on Russia and has a relatively low inflation.
According to the central bank of Estonia:
There are several reasons why inflation is higher in the Baltic states than the average in the euro area. The share of energy goods in the purchasing basket of consumers in the Baltic states is larger, which has affected the rise in the price of the consumer basket. Natural gas and electricity were a little cheaper in the region before Russia’s invasion of Ukraine, but prices have now caught up to those in other countries.15
Energy statistics – an overview (Eurostat)
From where do we import energy? (Eurostat)
European natural gas imports (Bruegel)
Carbon intensity electricity (Electricity maps)
Electricity prices (euenergy.live)
Real-time electricity tracker (IEA)
National policies to shield consumers from rising energy prices (Bruegel)
The financial news was dominated by the response to the Russian invasion of Ukraine
Listen to this episode on Spotify, Apple or YouTube!
Transcript:
“Dear President Lagarde,
I wish you a happy and healthy 2022!
And maybe also a career change?
You see, I follow you on Twitter, and I have the impression that this central banking stuff isn’t really your thing.
For example, you tweeted about your friends 13 times in 2021.
You tweeted about women issues 19 times.
Climate change? No fewer than 25 times.
Inflation?
Just 11 times.
I hate to bring this up on the first (working) day of 2022, but the primary objective of the ECB is still price stability.
With inflation close to 5%, it seems that talking and tweeting about the ECB’s secondary objectives is more important than delivering stable prices.
Within a year’s time, your economists have doubled their projections for inflation in 2022.
So you’ll understand that people don’t believe you when you say that inflation will go down this year.
If you do choose to stay ECB President in 2022, I wish you a firm hand.
On New Year’s day, the 20th birthday of the euro, you called the euro a “beacon of stability and solidity around the world”.
To keep it that way, the ECB will need your strong leadership.
Kindly yours,
Jan Musschoot
Hello and welcome to a special episode of the Finrestra podcast.
I wish you a happy new year! Stick around till the end, because I’m giving away 250 euros.
New year, new month, so here’s a quick recap of the European financial news of December.
Santander has to pay almost 68 million euros to Andrea Orcel. Santander had offered the former UBS banker the role of CEO, but withdrew its offer.
In other legal news, a French court has reduced a 4.5 billion euro fine for UBS to 1.8 billion euro. The Swiss bank was found guilty of money laundering.
Dutch green bank Triodos will set up a multilateral trading facility for its shareholders (technically certificate holders). Since the beginning of 2020, shareholders cannot sell their certificates. It is expected that trading will resume at a price that is 30 or 40 percent lower than before the pandemic.
There was also consolidation and divestment news.
BNP Paribas has agreed to sell its American subsidiary Bank of the West for 16.3 billion dollars. Listen to episode 9 of the Finrestra podcast for our take on this transaction.
ING announced that it is leaving the French retail market.
Cooperative bank Crelan acquires AXA Bank Belgium. The deal had already been announced in 2019, but was waiting for approval by the ECB. The new bank will be the fifth largest in Belgium.
Regular listeners know that I usually do an in-depth analysis of one topic after the news. However, today I want to tell you a bit about Finrestra and my plans for 2022.
I started this podcast because there are not many podcasts focused on European finance. My original goal was to do a weekly interview. But I quickly found out that this is easier said than done. Weekly episodes require more time than I have. And it hasn’t been easy to find people who want to come on the show. So I want to thank my first guests Uuree Batsaikhan, Koen Vingerhoets and Rik Coeckelbergs again!
For 2022, there will be two episodes per months. I hope that from February onwards, I will be able to interview a number of very interesting guests. Stay tuned!
If you’re listening to this podcast on Apple or Spotify, you may not know that there is also a Finrestra YouTube channel, where I post short videos about financial topics. For example, I have a series of bank profiles, including of Santander, Triodos, BNP Paribas and ING, which were all mentioned in the news recap. I also want to create more videos with short stories about European finance.
But neither the podcast nor YouTube pays my bills, and this is where you can help me. Don’t worry, I’m not asking for money, I’m giving you a chance to win money!
Finrestra stands for Financial Research and Training. So far, we have mainly worked for Belgian based clients. But I want to expand my activities to the rest of Europe. If you share my YouTube video with my two courses for 2022 on LinkedIn and tag a friend before 25 January, you can win 250 euro. I’ll put the link in the description.
This has been another episode of the Finrestra podcast. You can find my on twitter @janmusschoot. You can mail me at jan dot musschoot at finrestra dot com.
Thanks for listening and I hope you have a great 2022!”
This is the blog version of episode 12 of The Finrestra podcast: “What can the ECB do when inflation is driven by energy costs? Three proposals” (listen on Spotify, Apple Podcasts or YouTube).
Euro area inflation was estimated at 5.1% in January 2022. That’s mainly due to energy costs. Furthermore, businesses will try to pass on their higher costs (transport, heating, materials) to consumers.
According to Isabel Schnabel, “Monetary policy cannot reduce the price of oil or gas.“
I disagree, as I told the ECB back in 2020. If instead of government bonds, the ECB had bought a controlling stake in oil & gas majors, it could force them to lower prices.
That’s probably too radical for conservative central bankers.
But there are other, more conventional paths.
Energy makes up about 11% of Eurostat’s basket of harmonized index of consumer prices.
What if that percentage was lower? Volatile (fossil) energy prices would have less of an effect on inflation. This would make the ECB’s job easier.
To be clear, I’m not suggesting that the ECB interferes with how Eurostat measures inflation.
Rather, the central bank could reduce our dependence on (fossil) energy.
How? Years ago, in 2017, I wrote a proposal for green investments in Europe. A European Green Infrastructure Company (EGIC) would install solar panels, build energy-efficient schools, networks of charging stations for electric vehicles… All of this infrastructure would be funded by the ECB. Why? It’s hard to imagine now, but we’ve had years were inflation was too low, i.e. below the target of the ECB. In my proposal, the EGIC would build in countries with low inflation and high unemployment. In case of the economy is overheating, new projects would be put on hold, so real resources like workers, machines and building materials can be used elsewhere in the economy.
If the EU had done this, there would be an abundance of renewable energy. This would price fossil fuels out of the market, making international energy prices almost irrelevant for European inflation.
Of course, in the real world EU politicians and central bankers have wasted the opportunity of low inflation and low interest rates.
But it’s never too late. Even without a European Green Infrastructure Company, the ECB can reduce the weight of (fossil) energy in consumers’ expenditure. High energy prices make it attractive to make buildings more energy efficient. In fact, central bankers like Isabel Schnabel have argued that the slow transition to a carbon-neutral economy is a market failure (see also this video).
The ECB could correct this market failure by making loans for energy-efficiency cheaper, for example by charging a negative rate of -5%. Banks would pass this on homeowners and landlords. At the same time, the ECB could raise rates on other loans. This would stimulate investments in building improvements, and reduce the demand for consumer loans. Companies would respond by increasing the production of building materials. It would also alleviate the labor shortage, because workers would be attracted by higher wages in the renovation business relative to other jobs.
Further reading:
The ECB can help fix the energy price crisis: Play the long game
Even with inflation at 5%, some people believe that higher interest rates will crash the economy. Is this 2011 all over again1?
As I explained on Twitter, increases in debt servicing costs are small compared to rises of other production costs (e.g. labor). So if the economy does crash after rate hikes, it must be because of some other/indirect cause.
As always, I start the first Finrestra podcast episode of a month with a selection of the financial news of the previous month. Listen to the episode of 7 February 2022 on Spotify, Apple Podcasts or YouTube.