 At the end of July we raised our key interest rates for the ninth time in a row to the highest they've been in over a decade. We started doing so one year ago to bring down high inflation. Today we want to talk about exactly how our interest rates are working to bring inflation back down. Raising interest rates is the best contribution we can make to reducing the burden inflation is having on the economy, on companies and on people. Welcome to the ECB Podcast Summer School, helping you understand what's going on in the economy and central banking. My name is Katie Ranger. I'm joined again by ECB Chief Economist and Professor Philip R. Lane who will be explaining this to us today. Hi again Philip. It's a pleasure to also talk about the interest rates with you. Now this high inflation that we've been seeing has been primarily linked to supply bottlenecks, Russia's war in Ukraine and the related energy shock. Some say central banks cannot even influence the factors pushing up prices right now. So how are our interest rate hikes helping to fight inflation in this environment Philip? I think the most direct way to think about it is in the end who sets prices and firms set prices. When they try to work out what is the price I can charge in a given month, in a given year, they will look at all of the cost factors you mentioned, but they will also look at the level of demand. For some firms that demand is coming from households. So in the supermarket, in the restaurant, in the tourist hotel, it's the person on the street, the family. And for other firms, it's business to business. They're looking at the customer. It's some other business who's demanding their product. But whether it's a firm or a household who's the customer, their level of demand will be influenced by interest rates. So let me zoom in on households. What kind of activities are funded by interest rates? Most obviously it's going to be houses because people typically have a mortgage if they want to buy a house. So high interest rates have a pretty visible effect on the housing market. And of course, if the housing market cools down, there's lots of connected activities because if people don't buy a new house, they're not going to buy a new fridge, a new TV, new home furnishings. So one basic mechanism is true houses. A second mechanism probably next in the lineup for typical people is cars. Many people finance a car either by a lease or a car loan. And again, a higher interest rate will reduce their willingness to buy these products. On the other side of it, many, many people are savers. And if there are higher interest rates, people will essentially think twice about consuming. They might say, and across everything, across every service they consume, every good they might buy, do I really want to buy this because I could just leave my money on deposit and receive a high interest rate? So that will also cool down demand. Now I focus so far on households, but probably the single most important category is going to be the decision of businesses. Businesses are much more likely to take out debt than households. So businesses who want to fund investment or even working capital in the sense of in any given month, businesses may need some short-term loans because while they're waiting for customers to pay their bills, for example, or they have to finance imported goods from the rest of the world and before they sell them, there's going to be a gap when they need some financing. So it's a pretty immediate cost to business. So the cost of doing business goes up. And so those businesses will be looking to pull back. They will pull back from investing in new equipment, in new factories, for example. And again, just as we mentioned for households, if businesses are making money and the interest rate is high enough to me, they say, well, why should I invest? Maybe I should put my money on deposit in the bank or put it into the money markets more generally. So interest rates, if you like, are famously a blunt tool. They're not very selective. They operate across the whole economy, but clearly they have a much bigger effect if you're in the age group where you want to buy a house, if you're in the type of industry where you need a lot of debt to finance your activities. So it's blunt. It doesn't matter equally for everyone. But in overall terms, and this is what we're now seeing one year into this hiking episode, it is clearly starting to have a visible effect on the level of demand in the economy. Now you mentioned the way in which it immediately affects businesses, and I want to talk about that time element a little bit. As you've just said, many people have been feeling the higher rates mostly through more expensive and also harder to get loans as banks make it more difficult. They tighten their credit conditions. But higher rates also mean that savers are finally getting some return on their deposits again. But at the same time, monetary policy does take time to really affect the economy and prices. And it works with what we call a lag. Now there are different things that affect this lag. For example, on the one hand, we have some countries here in the Euro area where fixed rate mortgages are more the norm. And here, higher interest rates only kick in when the fixed interest rate term ends, which could make this lag longer. On the other hand, higher interest rates tend to focus mines on high debt levels and that could speed up the effect of tighter monetary policy as people and businesses cut spending to pay off their loans instead. Let's talk about the lag, Philip. How long will it be and when will the rate hikes really show their effects in the economy? Well, as I just said, we're about a year into this hiking cycle, depending on how you define it. And this is really visible now, but I'm pretty sure it's going to deepen in the next number of months. So we often think that essentially maybe the peak is around a year and a half. So as we go into the autumn, it's going to be more visible and it's going to continue to be working in 2024 and in 2025. So it is a multi-year process. It helps explain why we have a medium-term focus. We do not promise that inflation drops very quickly. And let me come back to connecting it to, if you like, the behavior of firms and of individuals. So as you say, some people in the initial phase might be insulated because they've got a fixed rate mortgage. By the way, most loans to firms are floating rate in most countries, so firms will see it more quickly. Another basic factor I think we all recognize is many people are not kind of looking at the markets or their bank accounts for that matter day by day. They might have a kind of annual plan and they wait until, if you like, they may be at the start of every year. They think, okay, how should I revise my kind of spending habits? For a firm, they may make decisions every quarter. And just as we've talked about before in different episodes, that the world is full of uncertainty. So decision makers in firms, individual people will also have to deal with that uncertainty. And they may say, well, I'm going to wait and see where this settles down. So we do think it's very natural, there are lags. And let me emphasize also something that you raised is compared to 20 years ago. And it is basically 20 years since we last had a kind of significant hike in interest rates. At that time, overall debt levels were lower than they are now. So even if, as you say, in terms of mortgages, there are more fixed-rate mortgages than there were, the overall level of that is higher. So in terms of the consequence of higher interest rates, I think that matters. Because it's more widespread, essentially. Right. Or also those who are indebted tend to be more intensely indebted. But let me also mention something that I've been mentioning in different contributions. It is in the modern economy, let's think about the tech sector. I think one thing that's been visible is in the modern economy, famously in various tech industries, firms tend to be valued not so much on the profits to make now, but the promise of high profits in the future. And the promise of high profits in the future has been able to attract funding today because venture capitalists, other investors are prepared to wait for those profits. But with high interest rates, that calculation changes. So with high interest rates, it's expensive to wait five or 10 years for future profits. And we are seeing some degree of shakeout in the tech sector. So that's another way interest rates work. They reduce the value of future profits. And that I think is very important in the world we live in now where a lot of activities, innovation, and where innovation often means delayed profitability far into the future. So we do have to think about these factors quite a bit. Now, in addition to the discussion about lags that we've just talked about, experts are also debating how high our rates will go and for how long they'll stay there. But I want to look actually further into the future to when these shocks that we've been seeing have subsided. We've come from a long period of super low rates. We needed these to fight inflation that had been too low for a long time, unlike what we're seeing today. Philip, do you expect us to go back to an environment with super low rates after all these shocks have subsided? And is the era of cheap money, shall we say, over? So that's a great question. And what I would say is essentially we have basically one cycle following another cycle. So until 2021, more or less, we were definitely in a long multi-year cycle where inflation was well below our 2% target. And we had launched essentially a campaign of negative interest rates and also a lot of other unusual policies. Now we're in a different phase of the cycle where inflation is too high for too long, well above our target, and we've moved interest rates quite a bit. So then all of that does raise the question you've posed, which is when all of this settles down, where are we going to be? So let me give you three answers. One, the markets sink a number of years from now. More or less, our policy rate will have come down to about 2%. So today the ECB policy rate is at 3.75%. So after this episode is over, the prediction is the interest rate will be about 2%. The second answer is we also ask various economic experts and more or less, the timing is a bit different, but more or less they give the same answer. They expect interest rates to be around 2%. So before the pandemic, our policy rate was minus 0.5%. So what that says is we're not going back to minus 0.5%. We're going back to some number around 2%, if these external views are correct. That's much lower than it is today, but a lot higher compared to that kind of extraordinary period. Let me come back to the connection with inflation. If we end up with a situation where our policy rate is around 2%, inflation is at our target of around 2%, that means that if you net out the effect of inflation, what's called the real rate of interest would be around 0. And famously, a real rate of around 0 is low. So what I would say is in terms of the underlying assessment of where the world economy is going, the calculation of the markets, the calculation of the experts, including our own experts, broadly speaking at the ECB, is essentially the world looks like it needs a kind of a long-run inflation-adjusted real rate of around 0, which is low. So not going back to super low. So let me say low, rather than super low is where I think we're going to be. Now, as you know, Philip, we always ask our guests to share a tip, maybe a book, a film, a story with our listeners about the topic we've been discussing today. What would you have linked to interest rates, shall we say? So I think there is a perfect book. It came out not too long ago and is written by Edward Chancellor, and it's called The Price of Time. So this is going back, if you like, to many centuries. And in terms of the overall explanation of why we should think about the interest rate as the price of time, I think it captures a lot. I'm not going to necessarily endorse all of his views. In terms of having the grand sweep of this kind of age-old topic of the interest rate, which, as you know, in many cultures has been hotly debated, is, I think, a great introduction. OK, The Price of Time by Edward Chancellor. Super, thank you so much, Philip. Well, that brings us to the end of this episode. I want to thank ECB Chief Economist Philip Arlayne for explaining how our monetary policy is working its way through the economy. Listeners, be sure to check out the show notes for more on this topic. You've been listening to the ECB Podcast Summer School with Katie Ranger. If you like what you've heard, please subscribe and leave us a review. Until next time, thanks for listening.