The US Federal Reserve is willing to accept a decline in economic power in order to combat high inflation. The European Central Bank faces the same dilemma. FOCUS Online explains why there is a connection between the two phenomena.

“Nobody knows if this process will lead to a recession and if so, how severe it will be,” US Federal Reserve Chairman Jerome Powell said after the Fed overnight hiked interest rates by 0.75 percent and another hike of 1.25 percent before the end of the year. “Nonetheless, we stick to bringing inflation back down to 2 percent.”

What the Fed chief is saying: Even if the rate hikes have to be so severe that they stall the US economy and reduce gross domestic product (GDP) for at least half a year, the Fed will not deviate from its path. It’s not just numbers games. A recession is always associated with suffering. Companies would earn less money, so they would have to save and thus cut jobs. The Fed currently expects the unemployment rate to rise by 0.7 to 4.4 percent. That would be around 1.1 million additional unemployed.

What is happening in the USA could become the blueprint for the euro zone and thus also for Germany. Finally, the European Central Bank (ECB) has followed suit, already raising interest rates by 1.25 percent and holding out the prospect of further increases. The central bank is also risking a recession within the euro zone in order to combat inflation. In case you don’t understand the connection between these things, here is the explanation.

The interest rate that central banks are currently raising is the rate a bank has to pay to borrow money from the central bank. In order to pay the interest on it, the bank has to lend the money to companies, governments or individuals in the form of loans at a higher interest rate than the base rate – otherwise the bank would not make a profit.

If the central bank increases the key interest rate, the lending rates will automatically rise as well. This makes it less attractive for bank customers to take out loans. Companies will then invest less, for example not building the new factory or buying expensive machines. Private individuals also borrow less, for example postponing the purchase of their own home or buying a smaller property for which they have to take out a smaller loan.

As a result, the demand for goods in general falls. So if you want to sell a property, factory or machine now, you have to lower the prices for it. In a second step, the prices of many other products also fall: if a company has to pay less money for the new factory, it can manufacture products more cheaply, so prices for them also fall. However, it may be more than a year before higher rates are reflected in consumer prices.

In addition to the base rate, the ECB still has the somewhat lower deposit rate. This is interest that commercial banks earn on money they save in accounts with the ECB. Banks also pass this deposit interest on to their customers – in the form of higher savings interest.

However, fewer loans and investments also have an unpleasant side effect: less is consumed. If fewer people are buying houses, sales in the real estate market will fall. If companies don’t invest in the new factory, bigger office, or better machine, they make fewer new products and offer fewer services.

In addition, higher interest rates on savings make it more attractive for consumers to save part of their money instead of spending it. This reduces the demand for products.

Both effects do not necessarily lead to a country’s economic strength falling. In any case, they slow down economic growth. The danger of a recession arises when central banks keep raising interest rates. But that is exactly the case at the moment, because after all, the inflation rate at eight percent in Germany is seldom as high.

It is surprising to many economists that we are not already in a recession. There is no precise definition of it, but most people think of a recession as two consecutive quarters of negative economic growth. While Germany’s economy grew by 0.8 percent in the first quarter of 2022, it stagnated in the second quarter. Most economists had already expected a decline here.

However, postponed is not cancelled. By winter at the latest, GDP is expected to start falling. “The signs are increasing,” writes the Bundesbank in its current monthly report. The Federation of German Industries (BDI) is becoming clearer: The industry “is likely to go through a severe recession in the next few months,” he writes in his quarterly report. As shown above, industrial companies would be the first to feel the effect of higher interest rates. In addition, energy prices could continue to rise in winter. Experts are therefore assuming a decline in GDP between October and March – that would be the picture book definition of a recession.

Probably not. Fed Chair Powell’s statement on the situation in the US shows that central banks must choose evil. Either they leave inflation high and the economy hums better, or vice versa. According to its mandate, however, the ECB is primarily committed to price stability in the euro zone, which means nothing other than that it should fight inflation when in doubt. It will fulfill this task in this crisis and therefore prefer to risk the recession.

In addition, there would probably be a recession in Germany and/or the entire euro zone even without intervention by the ECB. “But that’s not enough to reduce inflation,” said ECB Vice President Luis de Guindos from Spain this week at a congress in Cologne. “Monetary policy must make a contribution.”

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