As the European Central Bank (ECB) grapples with inflation caused by the war on Iran, it raises the question of whether raising interest rates would be an effective response. Raising interest rates may seem like an appealing option for the ECB, but it would have negative consequences. An indiscriminate rate rise would deter investments in the energy transition, thus helping perpetuate Europe\u2019s fossil fuel dependency which lies at the heart of current price instability. The ECB should instead focus on the root cause of the problem and support investments in the energy transition.<\/p>\n<\/div>
The US-Israel war on Iran is disrupting fossil fuel prices across the world and reviving fears of persistent high inflation as experienced after Russia\u2019s invasion of Ukraine. Given the predicted long-term impacts of this crisis (1), the ECB will likely start raising interest rates in the next few months, maybe as early as 30 April (2) at the next ECB Governing Council meeting. But before they do this, the ECB should consider which policies would truly contribute to price stability in the medium- to long-term.<\/p>\n<\/div>
The war on Iran has created price instability largely because of the impact on the price of oil and gas (which in turn affects prices across a whole range of sectors). In the first days after the start of conflict, oil prices spiked by 8% and European gas prices went up by 20% (3). The sharp increase in fossil fuel prices is now fueling inflation. In the euro area, it pushed annual inflation to 2.6% at the end of March, compared to 1.9% in February (3).<\/p>\n
This is just the latest example of Europe\u2019s exposure to energy prices shocks, resulting from its dependency on fossil fuels. This is why transitioning away from fossil fuels is as essential for price stability as it is for combating climate change. By reducing its dependency on fossil fuels, Europe would become less vulnerable to energy shocks.<\/p>\n
In the European Union, countries that rely less on gas power, such as Spain, are less exposed to electricity price increases (5). Deploying renewable energy to displace fossil fuels in Europe should therefore be a top priority, including for central banks.<\/p>\n<\/div>
As a result of the fossil fuel price shock, the ECB is considering raising interest rates to curb inflation. But doing so is likely to have severe unintended consequences. Higher interest rates mean higher borrowing costs, and these will make the energy transition more expensive, and most likely result in delays. During the previous energy crisis, renewable energy companies and associations raised the alarm about the additional costs induced by the rate hikes and the impact on the energy transition (6).<\/p>\n
Their concerns were well-founded: new research shows that the ECB\u2019s decision to increase interest rates leads to a decrease in new installed capacity for onshore wind and solar photovoltaic (7). In contrast, fossil fuels are not affected by such rate hikes, notably because of their cost structure, with higher operational and maintenance costs than renewables but lower upfront capital investment. Raising interest rates is not neutral: it disproportionately affects renewables over fossil fuels.<\/p>\n
By increasing interest rates, the ECB is helping perpetuate the EU\u2019s dependency on fossil fuels and ultimately contributing to price instability in the long-term.<\/p>\n<\/div>
A solution exists to protect the investments necessary for the energy transition from high interest rates. The ECB could launch a new set of Targeted Longer Term Refinancing Operations (TLTROs). TLTROs were designed to offer lower interest rates to banks on condition that they fulfil certain lending criteria. These could be repurposed to offer lower interest rates only for lending which contributes to the energy transition, such as renewable deployment, electrification and grid upgrades (8).<\/p>\n
Green TLTROs could counteract the negative effect higher interest rates have on the energy transition and help reduce the EU\u2019s dependency on fossil fuels. Green lending operations have already been deployed by other central banks \u2013 in China, Japan, Malaysia and Hungary \u2013 (9) and were once considered by the ECB (10).<\/p>\n<\/div>
The ECB President Christine Lagarde (11) and ECB Executive Board Member Frank Elderson (12) have called for an end to fossil fuel dependency for the sake of price stability. However, they seem to have overlooked the role that they play in this situation. If they tighten monetary policy, it will mean less investment for the energy transition and will disproportionately impact the deployment of renewables, thus perpetuating Europe\u2019s dependency on fossil fuels.<\/strong><\/p>\n To achieve this transition, the ECB needs to think carefully about its monetary policy and the unintended consequences of policy rate adjustments. If the ECB is serious about the need to have an energy transition that serves its price stability mandate, it should consider policy instruments such as green refinancing operations to support this transition, especially in times of high inflation. The ECB has the tools to avoid repeating past mistakes. Will it use them?<\/strong><\/p>\n<\/div><\/div><\/div>