Italy’s central bank chief Ignazio Visco has warned against further raising interest rates to tackle inflation, in a lecture at the University College London on Thursday (20 April).
“It is wrong to do too much. The risk of doing too much is at least as large as doing too little,” he said in a lecture hosted by the Official Monetary and Financial Institutions Forum (OMFIF). “It generates financial risks and could cause people to suffer greatly.”
The European Central Bank (ECB) is expected to raise rates for a seventh time on 4 May to bring down core inflation (the change in the costs of goods and services excluding food and energy sectors).
This week, prominent hawks like Dutch central banker Klaas Knot were pushing the ECB to keep raising rates into the summer.
But Visco pointed out that despite raising rates by a record 3.5 percent between June 2022 and March this year, core inflation is still trending upward in the eurozone, even as energy prices have dropped — prompting Visco to describe the rate-hiking policy as “ineffective.”
Increasing the cost of borrowing reduces what companies and consumers can spend. This pushes down wage growth. Eventually, unemployment rises, which is the main function through which higher rates minimise inflation. But it only works when domestic demand exceeds supply, which is currently not the case in the eurozone, according to Visco.
In a series of graphs produced by Banco D’Italia economists, Visco showed demand for services in the eurozone has not grown since 2019, and demand for goods has fallen compared to four years ago.
And while real wages in the US rose six percent in the year following the Covid-19 pandemic — a consequence of president Joe Biden’s enormous economic stimulus— support in the eurozone was not as impactful, and disposable income in the eurozone did not rise.
According to Visco, inflation in the eurozone is not caused by high demand or wage growth but is driven by high-profit margins. If “profit margins are not falling” along with energy prices “or are rising,” this could “perpetuate” core inflation, he said.
Profit-flation
In an ECB report titled ‘How tit-for-tat inflation can make everyone poorer’, published on 30 March, senior economist at the ECB Gerrit Koester concludes that “the effect of profits on domestic price pressures has been exceptional from a historical perspective.”
While unit profits contributed about one-third of price increases on average since 1999, in 2022, they contributed twice as much.
Amherst University professor of political economy Isabella Weber launched the debate about the impact of profits on inflation in February when she showed companies have used supply bottlenecks following Covid-19 as an excuse to gauge prices and increase their profits even more.
Company profits are not directly affected by higher rates and are better addressed by fiscal authorities — for example, through an excess profit tax.
Although Visco was careful not to exceed his mandate and issue fiscal policy advice, he argued “monetary policy should not be the only game in town” and called on fiscal authorities to help address the causes of inflation.
In a recent speech, Dutch hawk Knot said there was “no room for complacency” and called for continued rate hikes into the summer.
But according to Visco, “being cautious [on rate hikes] is not the same as being complacent. I strongly come out against that.”