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The European Central Bank’s strategy, environmental policy and the new inflation: a case for interest rate differentiation

How the European Central Bank (ECB) raises interest rates this year will shape the European economy for the next few decades. In particular, a sharp rise in funding costs could potentially gravely harm investments needed today for clean energy production, energy efficiency and adaptation to increasingly extreme weather and environmental degradation. Cutting off investments now would make the EU economy more vulnerable to geopolitical and climate-related inflationary shocks.

This report draws attention to some of the important lessons learned from the past few decades regarding the economic pre-conditions for price stability, as contained in the ECB’s 2021 strategy. The report revisits lessons learned on the interaction between monetary policy and sovereign debt markets. For private sector investments, it focuses in particular on interest rate differentiation. The primary aim of the report is to suggest that all these arguments continue to apply, and may in fact become more relevant, as the ECB moves out of its earlier deflationary environment.

The author argues that:

  • Although at its creation the ECB’s monetary strategy was focused on consumer prices on a two- to five-year time horizon, its 2021 strategy suggests a much longer-term orientation. A myopic hike in interest rates would ignore lessons learned during the eurozone crisis, and should be prevented at all costs.
  • To ensure its adequate long-term orientation, the ECB should use the full range of tools it has at its disposal. Now that net Pandemic Emergency Purchase Programme (PEPP) purchases have come to an end, the ECB should develop a new instrument that effectively counters fragmentation in sovereign debt markets. The ECB should also profoundly rethink its Targeted Longer Term Refinancing Operations (TLTROs). Rather than boosting demand, the instrument should be used to align bank lending with the EU’s long-term economic strategy, in particular the May 2022 REPowerEU action plan.