When monetary policy gets complicated

Last week, president of the European Central Bank (ECB) Christine Lagarde pledged to deliver “whatever rates are needed… to deliver on our 2% inflation target in a timely manner”, pointing out that underlying inflation components remain far too high^[1]. “We would echo that sentiment and continue to expect more hikes, on top of February’s increase of 50 basis points to 2.5% in the deposit rate.”, argues Ulrike Kastens, Senior Economist Europe at DWS, “We also think it is premature to pencil in an end to the rate hiking cycle just yet.”

Perhaps a more interesting question, though, is why so many market participants appear to feel far more certain than the ECB itself that they already know what rates will be appropriate. For most central banks it has been a long time since interest rates have increased as much as quickly. Economies have changed since then. Rules of thumb dating back to Milton Friedman suggest a time lag of at least 12 months. Those currently invoking them, however, usually seem to forget that such estimates often came with the strong disclaimer that lags tend to be rather variable from one cycle to the next.

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Share of variable rate residential loans out of total new loan volumes for house purchases

Sources: ECB, Statistical Warehouse, DWS Investment GmbH as of 2/7/23

In recent years, few of today’s investors have spent much time in thinking through the monetary transmission dynamics during hiking, rather than loosening cycles. They might be overlooking that the Eurozone is still very heterogeneous, not least in terms of how monetary decisions impact different member states. Our Chart of the Week makes this point in one particularly important area where you might expect higher rates to slow economic activity. It shows the percentage share of adjustable-rate residential loans to households in the Eurozone as a whole, as well for its four largest economies. In Italy, that proportion (measured in terms of new residential loan volumes for house purchases) has risen sharply in recent months, hinting at the impact monetary normalization is likely to have in dampening construction there. To a lesser extent, that also appears to be the case in Germany.

Even among the big four, however, there are big divergences on just this one measure. Precisely why these differences – and even larger ones across all members - have persisted has been the subject of quite a few empirical studies in recent years, including by the ECB itself^[2]. Alas, as one paper calling for more research laments, “our theoretical understanding of the significance of credit cycles is still very limited^[3].” Or, as the psychologist Daniel Kahnemann, might have put it: “Our comforting conviction that the world makes sense rests on a secure foundation: our almost unlimited ability to ignore our ignorance^[4].”