The ECB raised its benchmark rate in 2011 from 1.0% to 1.5%. Since then the rate has moved down to 0.15%. After their benchmark rate was raised in 2011, the Euro area went into a recession. Did the ECB cause the recession by raising their benchmark nominal rate? Some say yes. I say the story is more complicated than that.
The Euro area’s core inflation rose during the tick up in the benchmark rate in 2011. Inflation began to rise in the face of wage cutting across the continent. Raising prices and cutting labor costs is not a good mix for society though. So the ECB acted to restrain inflation.
Core inflation has been falling ever since 2012 when it became clear that the ECB would commit to low rates for a long time. This is the Fisher Effect where inflation will adjust over time to the natural equilibrium between long-term nominal rates and the natural real rate.
A little more context for the Euro recession… Great Britain started to contract in 2010 before the Euro benchmark rate was raised. Loans to private sector were actually rising during the tick up in the benchmark rate. Germany did not go into recession. The recession centered around the periphery countries of Spain, Greece, Portugal and Ireland. So what happened?
The Euro area has become a net exporter since 2011, which implies that there was a decline in domestic consumption which raised the area’s “national” savings. The rise in “national” savings would need to be offset by a rise in their current account. The Euro area became a net exporter after the recession.
Do you remember the wage disinflation policy from Germany with their Agenda 2010? This policy spread through Europe and there was a contraction in demand through part of 2010 and 2011, not only at the household level but also at the public level. The effect was to raise national savings by lowering labor share, and thus increase their exports from maintaining a balance of payments internationally. The suppression of wages across Europe laid the foundation for their recession.
Wage shares fell most in Spain, Greece, Portugal and Ireland. The periphery countries had to lower their wage costs in response to Germany (and France) because they could not devalue their currency. The recession was centered most in these periphery countries. Credit markets were tight. Debt levels were still high.
There is much more to the story than just… The ECB caused a recession by raising rates. There was an adjustment process to transform Europe into a “net exporter” area. The process created an economic contraction first, then “net exporter” status second. The process was most damaging to the periphery countries. Now, even though Europe is a net exporter which many desired, domestic demand is so weak that their economy is struggling.
Since 2011, the nominal benchmark rate of Europe has dropped to near zero with projections to stay there for a long time. The Fisher Effect says that inflation will decline with lower nominal rates in order to seek the natural real interest rate equilibrium.
Bottom line: When you damage an economy by lowering labor share to increase export potential, you will need an ever lower nominal rate because potential output is reduced to a level where the economy cannot return to full employment. But inflation will go lower as a response to seek the integrity of the natural real rate. The result is a downward spiral… which is now visible in Europe.
Note: A large part of the reason why China did not have higher domestic inflation was due to the fact that their labor share fell a lot over the past 15 years.