How the ECB is slowing inflation even without raising its policy rate

Impact of monetary policy on the economy and inflation

The ECB influences inflation through its policy rate. This is the interest rate that banks are paid when they hold reserves at the ECB. The ECB's policy rate was at a historically low level of -0.5% for quite some time, but has been raised to the current level of 4% in response to soaring inflation. An adjustment in the policy interest rate trickles through to the rest of the economy. A higher policy rate makes it less attractive for banks to lend money, so if businesses or households need a loan, the bank charges them a higher interest rate. The interest rates on corporate loans and mortgages have risen significantly over the past two years. For example, the average interest rate on a new mortgage loan in the Netherlands is now over 4%, compared with interest rates below 2% at the end of 2021.

These higher interest rates reduce lending to businesses and households. Saving also becomes more attractive. As a result, the economy shifts into lower gear, ultimately pushing down inflation. This is reflected in the figures: average inflation in the euro area peaked at 10.6% in autumn 2022, but stood at just 2.9% last December. Part of this decrease is due to lower energy costs. But we also see a decline in core inflation, which does not include more frequently changing components such as energy costs and food prices.

Current interest rate level still curbing inflation

Inflation has declined, but is still above the 2% target. So why does the ECB not raise its policy rate further until inflation is actually back at 2%?

First, it takes some time for a higher interest rate to have an impact on the economy. In general, economists take into account a period of up to two years for the full impact of an interest rate hike to be felt. Second, the ECB can bring down inflation even with unchanged interest rates. This is because it is the interest rate level, not the change in interest rates, that determines whether the economy is slowed down. One way to assess this is by looking at the difference between the policy rate and what is known as the “neutral rate”. The neutral rate is the level of interest rates at which the economy is neither stimulated nor cooled, keeping inflation stable. As long as the policy rate is above this level, you can say that monetary policy has a tightening effect. This means that it curbs inflation.

The level of the neutral rate cannot be measured precisely and it can also change over time. Models can be used to estimate this, however. Because of the uncertainty involved, central banks use different models, looking at a range of different estimates. As shown in Figure 1, the current policy rate of 4% is well above this range. This means that the policy rate is still slowing down the economy and that the current interest rate level – even though it has been stable at 4% since September – is still helping to bring inflation down towards the 2% target.

Figure 1: The policy rate is well above the neutral rate

Source: DNB, ECB, Reuters and New York Fed. Note: The range shown in this Figure consists of neutral interest rate estimates based on Holston, Laubach and Williams (2016), Brand, Goy and Lemke (2021), Goy and Iwasaki (2023) and the long-term expectations of the euro short term rate (€STR) from the ECB's January 2024 Survey of Monetary Analysts. The policy rate refers to the Deposit Facility Rate (DFR). Market expectations are based on the €STR forward curve and adjusted for the DFR-€STR spread.

Incidentally, the ECB can tighten monetary policy not only with the policy rate. The asset purchase programmes of the past few years resulted in lower interest rates on loans with longer maturities. Currently, the ECB is reducing its balance sheet again. Considered in isolation, this leads to the opposite effect, namely higher interest rates on loans with longer maturities. This too contributes to reducing inflation.

Lower interest rates expected in the future

Based on ECB forecasts, we expect inflation to return to 2% in the course of 2025. As the inflation rate moves more towards the target, the need for tightening monetary policy decreases. We do not want inflation to fall below 2%. Indeed, the ECB uses a symmetric inflation target. The target is simply 2% and any deviations above or below it are equally undesirable. The ECB's forecasts include a gradual decline in interest rates, based on financial markets expectations (see Figure 1). Based on this forecast, monetary policy will remain tightening for some time, with the policy rate approaching the neutral rate only in 2025. Whether the market expectations are right depends on inflation developments. At each meeting, the ECB looks at how the economy and inflation are developing for its interest rate policy decisions.