On Monday, the Banco de Portugal (BdP) explained that the increase in interest rates by the European Central Bank (ECB) served to throw a "bucket of cold water" on the economy with the aim of 'stopping' the rise in prices and slowing down inflation. 

"The outbreak of inflation experienced in the post-pandemic period was met with an increase in reference rates by the ECB. Raising interest rates works like throwing a bucket of cold water on the economy, slowing down the increase in the prices of goods and services that we buy in order to bring inflation to the target of 2%", says the BdP, in a publication shared on the social network X (formerly Twitter). 

After the ECB raises the reference rates, what happens is that, in response, "the commercial banks increase the interest rates on their loans and deposits, discouraging and making the former more expensive and encouraging the latter".

In practice, explains the BdP, "this tends to lead to less consumption and investment, which cools the economy". 

"Throughout 2023, the ECB continued this cycle of increases, raising interest rates by 0.5 points at the February and March meetings, and 0.25 points at the May, June, July and September meetings", recalls the banking supervisor. 

2023 was a busy year for European monetary policy, with several interest rate hikes, totaling 200 basis points. What was this increase for?

1/6 pic.twitter.com/KSVL43k55f

— Banco de Portugal (@bancodeportugal) May 20, 2024

What is expected now? 

In mid-April, the ECB's vice-president, Luis de Guindos, told the European Parliament that the central bank will cut interest rates in June if the evolution of the data continues to show an improvement in inflation.

"We have been very clear about monetary policy. If things continue to evolve as they have been lately, in June we will be prepared to reduce the restrictions of monetary policy", said Guindos, in a hearing of the European Parliament's Committee on Economic Affairs.

Guindos said that inflation has been falling and that the ECB's projections foresee that it will maintain this trajectory, albeit at a more moderate pace, reaching the 2% target in 2025.

However, the ECB's vice-president acknowledged that there are some risks that could influence the evolution of prices, including the evolution of wages, productivity, unit labor costs, profit margins and geopolitical risks.

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