Inflation And The European Central Bank: It Is A Mess
The European Central Bank (ECB) frequently projects inflation numbers. Since one year, these inflation estimations are dramatically wrong. All the time. The inflation for April 2022 was measured with 7.4%.
This means that prices on average are 7.4% higher than one year ago. In May 2022, Philip Lane, Member of the Executive Board, released a document on the euro area outlook. He shows that the estimations of the ECB have been 100% wrong on multiple dimensions (Figure 1): The level of inflation was higher in realty than estimated. The direction of future price increases was wrongly estimated. From this perspective it is surprising how “resilient” the society, the media and politicians react. Not just regarding the level of inflation (we are at 7.4%; in words: seven point four) and raising prices but also given the error quote of the ECB.
It is also important to note that within the euro area, inflation rates vary. France with 5.4 percent, which is quite high — but relatively low when you compare it to Baltic countries. Estonia in April 2022 had an inflation of 19.1 percent. What does this mean? This means that prices increase at 19.1 percent whilst salaries are not increasing in the same amount. Therefore, the “free cash” of the households of families is decreasing. This allows people to save less or to reduce their consumption. Also, money stored on the bank account looses its purchasing power since, illustratively speaking, people can purchase less gas, energy and food than years ago.
If such elevated prices exist over a longer duration or, even more so, if price increases continue, people will get in trouble. Simply, because the costs of living raise much faster than their salaries. It is very simple maths.
Currently it is being discussed whether interest rates will increase in the future. In my mind, this discussion is happening with a number of misunderstandings. We think that “an increase in the interest rate” solves the problem. But, frankly, what “increase”?
We have to deal with the numbers. In economic theory, the money and wealth of the population is preserved when the interest rate is as high as the inflation rate. Prices increase by 7.4% per year? This does not matter so much, when the money on the bank account of people receives an interest of 7.4% per year. Put it in maths, this is: 7.4% — 7.4% = 0%.
But inflation of 7.4% does matter, when the interest rate is roughly 0%. This means that prices increase; but this is not compensated by money on the bank account receiving interest (because it is 0%). So what happens? Destruction of purchasing power, destruction of wealth.
So, what matters are the numbers. What matters is the difference between these two figures (inflation rate and interest rate). If the ECB increases the interest rate, the past years and decades show that this happens slowly and in small steps (e.g. 0.25% or 0.5%). So, can we expect an increase in interest rates this year? Yes. Will it matter? No. Because the increase will bring the interest rate to — maybe — 0.5%. Most probably, inflation stays between 5%-10% this year since inflation rates are quite sticky. Recall that inflation rate in Estonia is 19.1%. It will not drop significantly below 10% over night. For more details on why the inflation will not drop significantly soon but rather has room to increase, it is strongly recommended to have a look at the speech by Prof. Hans-Werner Sinn which is just available in German unfortunately. He argues that with the green transformation, energy prices, producer prices and unions demanding salary increases, the inflation of tomorrow is already in the making.
An estimate: This leaves us with the situation that the difference between the inflation rate this year (say 7%) and an increase interest rate (say 0.5%) is still 6.5%; this difference again represents destruction of purchasing power and wealth.
Hypothetically, the ECB could raise the interest rate to 7%. Then, simply speaking, the destruction of purchasing power and wealth could be stopped. But then, costs of debt would increase: People, organizations and countries who have debt would have to pay higher costs for their debt. France is an example. Its debt is at 2.8 trillion euro. With a current interest rate of 0%, the costs for this debt is very low. With an hypothetically elevated interested rate of 7%, the cost of debt at this size increases to hundreds of billions per year. This cannot work. Who should pay the installments, the cost for this debt?
So, yes, we will see an “increasing” interest rate. Psychologically, it will feel good. But from a simple perspective of mathematics, it will not matter.
European countries and societies will therefore face a very though dilemma: (1) Keep the interest rate where it is, which is close to 0%, and we have some economic growth but we destroy wealth and purchasing power through inflation. Alternatively, (2) increase interest rates by some percent and we can mitigate inflation a little but have the risk of an economic downturn and the risk of households, companies, countries, will get in trouble due to increasing costs for their debt.
To conclude, here are some tactics that can be possibly applied to mitigate adverse effects on your own money. But of course, these are just possible tactics, no financial advice: Purchasing other currencies helped back in 1922/1923 when inflation in Germany was high but significantly lower in other countries. But when inflation hits basically any country on our planet simultaneously, it does not help to purchase other currencies. Investing in real assets does help: real estate, gold, Bitcoin, selected high quality stocks. Real estate is not liquid and it is bulky, so it is not ideal. Stocks, gold and Bitcoin are better. As a digital bearer asset, Bitcoin can be owned without an intermediary. This can make sense in the future. Ultimately, a portfolio of real assets might be most interesting. Increasing your debt can also be an interesting idea, for example, by investing in real estate financed by a loan. Creating a Lombard loan on stocks or using real estate as collateral for a loan can also help possibly. But here is a warning: With inflation and interest rates rising, people need to care about their capacity to pay back their installments.
Forgive me aspects where I use colloquial words; but for me, it is very important to write in an understandable way to make people understand what is happening so they can act accordingly. To make education successful we must ensure that people understand it. We need simple words and simplifications. Using special terms from economics and complex works does not help. But, ultimately, what helps most? Maths.
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Prof. Dr. Philipp Sandner has founded the Frankfurt School Blockchain Center (FSBC). From 2018 to 2021, he was ranked among the “top 30” economists by the Frankfurter Allgemeine Zeitung (FAZ), a major newspaper in Germany. He has been a member of the FinTech Council and the Digital Finance Forum of the Federal Ministry of Finance in Germany. He is also on the Board of Directors of FiveT Fintech Fund, 21e6 Capital and Blockchain Founders Group — companies active in venture capital financing for blockchain startups and crypto asset investment management. The expertise of Prof. Sandner includes crypto assets such as Bitcoin and Ethereum, decentralized finance (DeFi), the digital euro, tokenization of assets, and digital identity. You can contact him via mail (email@example.com) via LinkedIn or follow him on Twitter (@philippsandner).