Analysts are forecasting that the European Central Bank (ECB) could start to increase interest rates as soon as next month in reaction to the growing inflationary threats facing the region’s economy.

Isabel Schnabel, member of the executive board of the ECB, warned last week that the effects on prices being felt from the conflict between the US and Iran could lead to a rapid change in inflation expectations, and this would not be something the ECB could ignore.

“If the energy price shock broadens, monetary policy will need to tighten to contain the risk of second-round effects threatening medium-term price stability,” she said in reference to the possibility of increased interest rates, adding that “this risk has increased in recent weeks”.

At the moment, financial markets are pricing in three or four 0.25 percentage point rate increases over the next 12 months, with two coming before the end of the year.

That would see base borrowing costs rise from 2% to near 3% by this time next year.

Since the outbreak of hostilities in the Gulf, the three-month Euribor rate has risen by around 0.25 percentage points

While increases in the central bank rate will feed through to borrowers in Ireland, the rate that is already been paid are well above the base rate. Many loans to companies are based off market rates such as Euro Interbank Offered Rate (Euribor) with a margin added by the lender.

Since the outbreak of hostilities in the Gulf, the three-month Euribor rate has risen by around 0.25 percentage points (see Figure 1) as market participants both reassess risk and anticipate the possibility of ECB rate rises.

While there is no indication at the moment that we will see a repeat of the extremely rapid increase in interest rates which followed the pandemic that saw the ECB policy rate rise from zero to 4% in little over a year, any increase in borrowing costs will put additional pressure on borrowers.

If there are four rate rises over the next year, it would increase the interest cost of every €1m of borrowing by €10,000 per year.

With companies already facing increased costs for everything from labour to transport to energy, this further cost will be very unwelcome and could serve to reduce economic activity.

For the ECB, this would be exactly the point of the rate increase. Economists at the bank see inflation as being caused by too much money chasing too few goods.

If inflation is rising, it is the ECB’s job – in fact its only job – to bring it back under control

The fact that there is a shortage of some key inputs, particularly on the energy side, driven by actions far beyond the control of the central bank is, in its view, immaterial. If inflation is rising, it is the ECB’s job – in fact its only job – to bring it back under control.

Schnabel explained that central bank’s independence allows it to “prioritise long-term price stability over short-term economic and political gains”.

It may seem counterintuitive for the ECB to be looking to increase interest rates just when all other input costs for businesses (and consumers) are rising. The bank is certainly aware of the pressure it will be putting on borrowers, but it sees the calculation as a trade-off between the risk of higher inflation and the risk of recession. For the bank, elevated inflation is the greater of those two evils.

If inflation was to become entrenched it would cause a cycle of higher prices pushing costs higher which in turn would lead to further price increases. This was seen in many countries in the 1970s, and it very severely curtailed economic growth. The central bank is willing to endure the risk of a short-term recession now in order to avoid an economic depression later.

For businesses, consumers, and even governments who have large debt servicing costs, this will mean some extra pain in the coming months. However, if the monetary medicine is not delivered now, it would risk significantly worse outcomes later. The best way to avoid much of this pain in the short term would be an end to the conflict in the Gulf and a reopening of global oil, energy and fertiliser flows. That, however, is not something central banks have any control over.