By David Born and Christian Krys

High inflation rates in the U.S. and in Europe - long characterized by optimists as "temporary" - have turned into a tenacious phenomenon which is clearly not disappearing on its own. Major central banks have reacted accordingly: The Bank of England raised its base rate from 0.25% to 0.5% in February. In December 2021, the U.S. Federal Reserve (Fed) announced that it would halt its asset purchase program by March 2022 – a move setting the groundwork for an ensuing interest rate hike. The Fed's monetary tightening has also put pressure on the European Central Bank (ECB): At a January press conference, ECB president Christine Lagarde said that the ECB would "leave no stone unturned" with regard to its monetary policy. Market experts and analysts saw the statement as a departure from the ECB's expansive monetary policy of recent years and expect a euro zone interest rate hike in the near future.

The actual or impending paradigm shift in the monetary policy of the leading central banks raises the following questions: What would happen if the ECB actually raised the key interest rates in 2022? What ramifications would this have for consumers and businesses as well as for national economies and governments? And what would be the resulting economic and social challenges?

First of all, it is essential to consider the current monetary environment in which a potential key interest rate hike would take place.

As a reaction to the financial crisis in 2008 and the subsequent national debt crisis, the European Central Bank lowered its key interest rates to support the economic recovery and prevent deflation. By 2015 the target interest rate had been lowered to zero without having achieved the desired effect. The ECB consequently expanded its monetary policy instruments to include what is known as "quantitative easing", i.e. a program for the purchase of government bonds and other financial assets based on similar programs created by the Fed or the Bank of England.

For the last six years, the key interest rates in the euro area have been at 0%. During this period, the European Central Bank's balance sheet has ballooned: Between 2015 and 2021 it tripled from 2.7 billion euros to 8.6 billion euros.

What would happen if the ECB reduced its bond purchases and/or raised the key interest rates in this monetary environment?

A look at the repercussions of the Fed's announcement at the turn of the year to tighten its monetary policy holds helpful lessons for the euro area.

Figure 2 shows that the mere announcement by the Fed to end its bond purchasing program in March 2022 not only drove up the returns on U.S. government bonds but also had a knock-on effect on corresponding securities in the euro area's biggest economies. This demonstrates that investors not only react to actual market developments such as interest rate increases but rather anticipate these developments and factor them in accordingly.

Rising yields on government bonds increase the refinancing costs for commercial banks, who then pass these costs on to their customers in the form of higher interest rates on loans.

This brings us back to our initial question: What consequences will the ECB's interest rate increase have for the individual consumer, for businesses, and for the national economy as a whole?

A general increase of the interest rate will result in higher yields on savings deposits for consumers and will also lead to higher price stability as a result of a declining inflation rate. At the same time, loans will become more expensive, hampering private investment. In addition, higher interest rates could have a negative impact on consumption, hurting economic growth.

For businesses, an interest rate increase and the resulting decline in inflation would have the benefit of reducing the risk of a pending price/wage spiral. Businesses profit from price stability (including with regard to wages), as this facilitates planning regarding future costs and profits. Yet, higher borrowing costs would also make it more difficult for businesses to follow through with planned investments.

A decline in inflation would primarily protect those parts of the population that are particularly vulnerable to an increase in consumer prices as they use most of their financial means for everyday necessities. On the other hand, rising interest rates make government borrowing more expensive to obtain government loans, which could dampen public spending and thus weaken growth.

Although this analysis and the data used therein predated the start of the current war in Ukraine, the overall trends, challenges and impacts described in our analysis are still valid. In fact, the current situation exacerbates the tightrope walk of central banks: Both inflationary pressures and risks to economic growth have increased due to the war in Ukraine.