Wednesday, November 13, 2013

EU interest rate cuts: Impact on the middle classes

The EU Central Bank has decided to cut interest rates. 

The European Central Bank (ECB) has cut its benchmark interest rate to a record low of 0.25%, down from 0.5%. The move came as a surprise to many analysts.

Why? We know that in the USA, they want to increase them. Why? What do interest rates do? Here is a simple, perhaps simplistic, response.

Interest rates determine whether you should invest or not. For most projects, interest rates are a cost that projects must cover. If your project is getting more than the interest cost, it's worth investing. Obviously, if interest rates are high, only very highly profitable projects will be taken up. So, investment will be very limited and therefore growth and new employment would be limited.

When interest rates are decreased, it is hoped that less lucrative investments are now worth investing in. So, more projects materialize. As investments increase, it is hoped that there will be growth and increase in employment.

Now, here is the catch. If there are bottlenecks, then instead of increasing employment, interest rate cuts cause inflation.

So, low interest rates can lead to high employment and high inflation.

High interest rates should lead to lower employment and lower inflation, even deflation.

The question in each country is what the employment situation is. If it's close to full employment, it's advisable to keep interest rates up to keep inflation in check.

If there is a lot of unemployment, it is advisable to lower interest rates because there is less risk of inflation.

Therefore, one can assume that if the US is increasing interest rates, it's because they feel either that unemployment is not a problem or that inflation is the greater of the two threats.

In the EU, with its vast unemployment in most countries, it is clear that there is little risk of inflation. In fact, the news reports say that the Central bank is afraid that inflation is less than 1% and we may go in for deflation, thus hurting growth prospects. In other words, the European Central bank is reducing interest rates to raise prices.

ECB president Mario Draghi said the decision to cut rates reflected an outlook of low inflation and economic weakness in the eurozone. Inflation in the eurozone fell to 0.7% in October - its lowest level since January 2010, stoking concerns of deflation in some countries.

This obviously merits further analysis.

Why do people not like inflation? Why should it be controlled? This is because it distorts the meaning of money. Partly. Partly also that it's a tax on fixed income workers and retired pensioners. Inflation erodes their purchasing power. Business people are able to raise prices and therefore profits. So, in fact, inflation usually takes away wealth from fixed income people, usually middle class and poor, and provides it to richer business income people.

The ECB's target is to keep inflation just below 2% - seen as a healthy level for economic growth.

To some extent, minimum wages and doles are increased in periods of inflation. However, very few countries have adequate indexation for inflation. And what indexation does occur, follows with a time lag of a year or six months.

This lowering of purchasing power eventually leads to strikes, protests and loss of valuable time and lower economic growth. So, inflation is not a tool that governments like. Yet with the growth mantra being so important to the rich (they always want more), when they find they cannot tax any more the middle classes, they try to usher in inflation.

Having understood that monetary policy is a risky tool, and there is no certainty of what it will really achieve, the task becomes even tough in federal country where different States have different levels of deficit financing. It becomes even more arduous in an economic union where each country has even less synchronization of economic policies.  

Prices in Greece – one of the urozone members worst hit by the economic crisis – have not risen since July. Some economists are also worried about deflation in Spain.

What is clear is that the lack of price increase is probably a source of solace for those in the middle classes who still have jobs, and so too for those on the dole.

Note : all italics are quotes from BBC, 7 November 2013

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