ECB rate increase - the logic there of ?

[drbob1972]

I'm hoping someone with a better understanding of economics than me can help to clarify the logic behind the likely ECB rate increase, given that the prime drivers for inflation are outside its control in fuel / energy costs and food costs, essentials for the majority of us, increasing interest rates will increase the cost of morgages, loans, etc and feed into an increase in costs, further eroding peoples spending power. Given the over all economic climate in the eurozone that ranges from slowdowns to recessions, surely this is only going to compound the problem for many?

[digoutday]

the remit of the ECB is to keep prices stable, i.e. keep inflation low, rising interest rate will in theory stop prices rising as there will be less money in supply...

[drbob1972]

the remit of the ECB is to keep prices stable, i.e. keep inflation low, rising interest rate will in theory stop prices rising as there will be less money in supply...

true if the main sources of these materials as domestic, which given the cost of oil and food (not to mention food transport) are not, apart from reducing discressionary spending it won't have much of an effect on inflation will it ?

[expat girl]

the remit of the ECB is to keep prices stable, i.e. keep inflation low, rising interest rate will in theory stop prices rising as there will be less money in supply...

true if the main sources of these materials as domestic, which given the cost of oil and food (not to mention food transport) are not, apart from reducing discressionary spending it won't have much of an effect on inflation will it ?

Nope, it won't, and it will make the reducing value asset spiral sooo much worse. The only way to stay ahead of this one is to reduce our dependence on oil faster than the supply is declining...although in fairness to those on the Continent, they have been trying this harder than the rest of us.

Europe needs an energy security and combat global warming Bill to go thru the Europarliament, not rising interest rates

[meriwether]

the remit of the ECB is to keep prices stable, i.e. keep inflation low, rising interest rate will in theory stop prices rising as there will be less money in supply...

true if the main sources of these materials as domestic, which given the cost of oil and food (not to mention food transport) are not, apart from reducing discressionary spending it won't have much of an effect on inflation will it ?

Increasing interests reduces demand.
If demand falls, costs fall. Ergo inflation falls.

[rockyracoon]

the remit of the ECB is to keep prices stable, i.e. keep inflation low, rising interest rate will in theory stop prices rising as there will be less money in supply...

true if the main sources of these materials as domestic, which given the cost of oil and food (not to mention food transport) are not, apart from reducing discressionary spending it won't have much of an effect on inflation will it ?

The idea, drob, is that people will spend less on more expensive items such as fuel or food by reducing their consumption of the commodities or finding cheaper alternatives. While one country hiking rates won't have a big impact, the reduction of the demand for the expensive commodities Europe wide will have a bigger impact.

On a more technical note, the higher interest rates will make borrowing more expensive, as you point, out which will limit the growth of money supply. (Money is created when individuals, companies, and governments borrow.) It is actually an expansive of money supply which only enables an economy to purchase the same amount of commodities for higher prices (more money)that defines inflation as it is an erosion of purchasing power by the economy in the long term.

[drbob1972]

the remit of the ECB is to keep prices stable, i.e. keep inflation low, rising interest rate will in theory stop prices rising as there will be less money in supply...

true if the main sources of these materials as domestic, which given the cost of oil and food (not to mention food transport) are not, apart from reducing discressionary spending it won't have much of an effect on inflation will it ?

Increasing interests reduces demand.
If demand falls, costs fall. Ergo inflation falls.

but will that apply to fuel / energy and food costs ? these are global commodities traded globally and also very much still in demand, just making things more expensive has not removed the demand for same, best i can tell is that the amount people spend of their disposable income (for which i mean wages less tax and less morgage / rent, etc) on basics such as food, clothing, heating, transport and less on holidays, new cars, electronic toys, etc. true manufactors in these sectors will have to compete more agressively then before and there will problably be cost reductions there but the main sources of inflation won't be impacted by same

[EGaffney]

You do have to differentiate between price rises and inflation also. One is about a level changing and the other is the rate at which it changes. e.g. high oil prices do not mean high inflation in the long run, they are just a series of upward shocks to the price level. However, if these discrete price rises lead to a price-wage upward spiral, then there will be pressure on inflation. The first step of this is happening already - people are expecting high inflation to prevail in the future.

So the ECB is essentially trying to control inflation expectations by limiting the only source of inflation it can control. But the traditional relationship is complicated by the fact that so many people now have a financial interest in low interest rates and will experience an interest rate increase like a price increase. A hit would happen anyway in the olden days of the 20th century, but it wouldn't be transmitted to consumers as quickly.

[rockyracoon]

but will that apply to fuel / energy and food costs ? these are global commodities traded globally and also very much still in demand, just making things more expensive has not removed the demand for same, best i can tell is that the amount people spend of their disposable income (for which i mean wages less tax and less morgage / rent, etc) on basics such as food, clothing, heating, transport and less on holidays, new cars, electronic toys, etc. true manufactors in these sectors will have to compete more agressively then before and there will problably be cost reductions there but the main sources of inflation won't be impacted by same

You have to understand how money is created drob and you will basically understand inflation. Inflation is not just the basic cost of the commodity. It is the relationship between the amount of money in an economy (and the potential amount of money in an economy generated by economic activity represented by lending activity) versus the cost of basic commodities.

Money is created, for example, when the Fed Reserve in the US buys back a bond from individual or institution. They pay you a $1000 for a bond. The Fed, which doesn't really have this money in its vaults, merely creates an electronic credit to your account in a given bank. Presto, $1000 which didn't exist a moment ago, now exists in your account. The money supply of the US has just increased by $1000. Now your bank can lend 10x this amount to other customers. The purchasing power of the US economy just risen exponentially if all the money is lent out at cheap interest rates.

But maybe the cost of labour is running too high, or maybe oil, etc. The availability of cheap credit is boosting demand for all commodities and reducing the buying power of your currency. You could have bought a barrel of oil for $80 last year and it now costs you a $140. Your purchasing power has decreased by $60. The Fed, now, could decrease interest rates to increase the money supply but this only leads to an upward spiral in commodity costs and money supply. Their solution is to increase interest rates to reduce your demand for money so that you don't have more capital to spend on the more expensive commodity and as a result they are restricting the money supply.

The basic idea isn't to decrease the price of a commodity immediately but to reduce the demand for money which in future impacts on the demand for the commodity. If there is a large speculative price built into oil prices, the reduced demand for the oil due to decreased economic activity should bring down the price because the increased interest rates have dampened demand for money to invest in oil. Alternatively, the economy as a whole begins to look for alternative fuel sources to replace oil.

[drbob1972]

thanks Rocky, informative post