Barring cataclysms, the European Central Bank will reduce interest rates on Thursday 6 June for the first time in 5 years. The last reduction in the cost of money was in fact September 2019. The series of increases had begun on July 27, 2022, when rates started moving higher again after staying for 11 years at zero or even negative levels. There was something to dispose of subprime mortgage disaster which brought the global financial system to the brink of collapse. A cataclysm averted only thanks to the action of governments (read citizens’ pockets) and monetary authorities who have burden of debts and they flooded the planet with money. The worst seems to be over but we’re not completely out of it yet.
However, in the meantime, the concomitance of a lot of liquidityshocks of the pandemic on supply and demand and repercussions of the war in Ukraine on the costs of raw materials have resurrected inflation. Which when it is high becomes the nightmare of every central banker and, in particular, of those of the ECB, shaped by the visions of German Bundesbank. By statute, the European Central Bank has the fight against inflation as its absolute priority, unlike the US Federal Reserve which places the fight against high prices of living on the same level as supporting economic growth, two objectives which Unfortunately they often conflict with each other.
With prices overheated, the ECB was forced to move even though the eurozone economy wasn’t exactly running as fast as a train. Within a year the rates have reached, with a series of 9 increases, 4.5%. The last increase is in September 2023. In fact, inflation drops from 10 to 2% in the following period, although the debates are endless and inconclusive between economists on why and how this happened. In absolute terms, the current level of interest rates is not exorbitant, but, after a decade of “monetary methadone”, the interruption was abrupt, painful for some, advantageous for others. So let’s see who they are the losers and the winners of this three-year period in which the cost of money has rapidly increased.
Who won – First of all and above all, the banks. Which throughout the eurozone, including Italy, have made a glut of profits practically without having to do anything. Shareholders rejoice over large dividends, rising stocks and stock buyback programs. Managers enjoy lavishly growing bonuses and salaries (not that they ever came down). Banks obtain around 60% of their revenues from the so-called interest margin, i.e. the difference between the rates they charge on the loans they grant to businesses and families and those they pay to depositors. When central bank rates rise, this differential widens.
The interest that the bank asks for rises instantly, as does the interest it pays they do it much slower and much less (especially in Italy). Not only did the increase in official rates also mean that banks obtained more interest on the huge funds that are deposited with the ECB itself. So, as we sit back and watch, profits have soared. In theory, some benefit should also have involved those who keep the money in the bank. But, of course, if the effect is that the interest paid by the bank goes from 0.01 to 0.02%, no one notices. Some governments have tried to patch things up by introducing a tax on bank extra profits or trying to do so (Italy) without succeeding. On the other hand, the observations of those who note that banks suffered when rates were at zero, forcing shareholders to subscribe to capital increases, seem to have little basis. This long phase of very low rates was necessary precisely because of the reckless and greedy behavior of the European and American banking systems which led to the 2008 disaster.
The fossil energy industry is another of the winners, albeit indirectly, of this situation. The profits of the gas and oil giants have been driven above all by the soaring costs of hydrocarbons, caused by the war in Ukraine and, to a lesser extent, by tensions in the Middle East and a small recovery in demand. However, these companies already have a huge network of infrastructure and plants. To produce more (within certain limits) they do not need to make huge investments which, with the higher cost of money, would be more expensive. The opposite is true for renewable energies which require significant investments to grow, become more expensive with the increase in rates. This reduces the profitability of the sector for investors. These two years have marked a revenge of the old “fossils” on wind and sun. This can also be seen from the performance of the respective stocks on the stock exchange.
Who lost – First of all families and businesses that had a mortgage or variable rate loan (therefore with installments anchored to the trend in interest rates) or who had to take out new ones when the cost of money had already risen. The variable installments have in fact grown significantly, several hundred euros per month and have done so very quickly, displacing those who had contracted a variable loan. One of the most significant phenomena of these three years was basically the transfer of wealth from debtors to creditors.
Among the debtors there are also the States, some more and some less. They are also going up the interest that must be paid on newly issued government bonds. Getting into debt costs more for everyone. Italy, with a debt of around 140% of its GDP, is one of the euro area countries most exposed to this dynamic. When rates were at zero, the cost of Italian “debt servicing” was reduced to around 57 billion euros in 2020 and then gradually rose up to 100 billion euros by 2023.
Although the metronome of international rates are the two largest central banks (ECB and, above all, Federal Reserve), their decisions have immediate repercussions on countries around the world. If rates go up in the USA and/or Europetheir respective currencies and their assets strengthen become more profitable. Which means that money previously invested in developing countries “comes home”. The game is no longer worth the candle, if I can earn decent amounts with an Italian BTP, why risk so much with a Colombian bond? This forces other countries to raise their rates in turn to contain capital flight. Thus in turn bearing a greater cost on sovereign securities and bonds, which, moreover, often they are denominated in dollars or euros.
The strengthening of the currency does not benefit ours either exporting companies. Their products become more expensive on foreign markets and demand falls, vice versa those of foreign competitors depreciate and become more competitive.
Even the bags, in theory, they don’t like rising rates. The money in circulation decreases, therefore also the amount to invest in shares. Growth slows and so do companies’ profits. Shares are nothing more than claims on these profits: if less are expected, their value drops. Yet from July 2022 to today the indices have risen. The Eurostoxx 50 (includes the top 50 listed companies in the eurozone) grew by approximately 30%. The resilience of the markets to a series of adverse events has indeed surprised many observers. The performances of the winning companies mentioned at the beginning, banks and oil companies, which have a significant impact on the price lists, certainly contributed. Furthermore, the good results of the technology giants (with new opportunities opening up in the sector) together with weapons manufacturers and pharmaceutical companies have contributed to pushing prices.
The inflation factor – The decline in inflation reinforces some of the trends that we talked about and attenuates others. High inflation in fact it is good for debtorssuch as the State, families or companies. The creditors, i.e. the banks, don’t like it. The relative value of the liabilities is in fact eroded by the general increase in prices. The combination of rising rates and falling inflation is a negative mix for state budgets. Inflation is also good for the profits of anyone who can influence prices and lists (companies and shops) and is harmful to those who live on fixed incomes (salaries).
What will happen now – Contrary to what many hoped, Thursday’s rate cut is pretty difficult marks the beginning of a series of close cuts. The latest data on inflation in the United States and the euro area still point to some critical issues. The Fed is quite determined not to force the times and the US economy is not suffering. The European one is more so but the ECB must also take into account what is happening on the other side of the Atlantic. An excessively marked differential in the rates of two continents would generate imbalances in relations between currencies and in trade.
