The rate hike to combat inflation and its limited impact on Europe’s real problem: energy costs

Rates are rising in the world’s major economies. The latest developments point to The US will continue to do so. this fall and Europe too (despite the recession they are causing in the US and the one that comes in Europe).

The reason is clear: to fight an inflation that has not been seen since the 1980s. And it seems that the determination of the central banks is as clear as at that time. The timid attempts of the 1970s to control prices only made inflation expectations take hold in people’s heads and returning to normal levels was more complicated and painful than necessary. Nevertheless it is not clear that simply raising the rates can be combatedthis time, the price increase.

The reasons for inflation

Raising interest rates has a clear effect on prices: it slows down investment, which detracts from demand, and in the face of lower demand, prices fall. The problem with this strategy is that it slows down the economy, and that is why the Central Banks have to do it trying to minimize the damage to the economy.

However, this time the rise in prices has a lot to do with the rise in energy prices, especially in Europe. And here the rate hike has a limited impactbecause there are other aspects that determine supply and demand.

Faced with a rate hike, demand falls, but in energy it is not so clear. Energy demand, at least from households, is quite inelastic: consumption is not going to stop because rates rise. Yes, the prices themselves have an impact and households will moderate their consumption to some extent.

In the industry, things are very different: they have two options in the face of higher prices, or raise prices in turn, or stop manufacturing. But the impact of this is simply the energy price and the rate hike will have a very limited effect.

energy problems

The main energy problem we have in the world (and especially in Europe) is the dependence on natural gas. Normally, when the dependency is on oil, the variations in supply and demand reach prices quickly. On the other hand, in gas it is more complicated, since the supply is usually mainly by gas pipeline and highly determined by local geopolitical issues (such as Russia and Europe).

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The transport of gas by ship is something relatively recent, it has a fairly high cost (because the gas has to be liquefied and deliquefied) and there is still a lack of infrastructure (few ships, few regasification plants, for example Germany does not have any).

And this has coincided with policies to combat climate change that have promoted the use of gas in the generation of electricity, for example leaving coal aside. If we add to this the pressure from Russia, we have a cocktail perfect for the price explosion we are seeing.

All this is not solved with a rise in interest rates. The only thing this increase can do is make certain transformations in the industry financially impossible and shrink demand by destroying the economy.

China follows the opposite path to the rest of the world: it lowers its interest rates and it is due to the slowdown

Changing the energy model is slow and costly. And therefore it cannot be solved overnight. Energy prices are going to continue to drive inflation no matter how high rates go, unless they go high enough to destroy the economy enough that energy demand drops significantly and with it the prices.

In the end, the way out of this inflationary crisis will have more to do with States’ ability to make gas cheapereither with lower consumption, with more liquefied gas transport vessels, with more regasification plants, going back to burning coal or intervening in the electricity generation markets, than with interest rates.

Source: El Blog Salmón by

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