By Yoruk Bahceli

(Reuters) – The Eurozone interest rate rise to at least 0% in September looks like a done deal, as inflation soars. But how high should rates go after that is a matter for debate between economists and policymakers from 19 different countries.

On Thursday, the European Central Bank will meet and it is likely to confirm that its July rate increase will be confirmed. The European Central Bank is now focused on finding the neutral interest rate. This neutral rate should be sufficiently high to control inflation without threatening growth, just like other central banks.

This is the difficult part.

This is a topic that’s hotly debated around the world. For example, economists are not in agreement with Federal Reserve’s long-term U.S. rate of 2.4%. It is more challenging for the ECB to accomplish its task given that it has remits ranging from Italy (with debt at 1500% GDP) to Germany (whose debt ratio exceeds half).

Unsurprisingly, the estimates of ECB policymakers as well as investment bankers diverge greatly.

Francois Villeroy, the Bank of France Governor and ECB official Francois Villeroyde Galhau believe that neutral rates should be between 1% – 2%. Peter Kazimir of Slovakia, who is hawkish, thinks that it could be close to 2%. Pablo Hernandez de Cos of Spain believes it might be around or slightly more than 1%.

However, when faced with rising inflation, policymakers are more likely to refer to the neutral rate to determine how much they should raise this cycle.

Andreas Jobst, Allianz’s global head for macroeconomics and capital market research said that “it’s a somewhat new way to communicate the monetary policy position that suits the situation.”

It is not useful in a supply-shock world. You need another way to anchor your forward guidance. The neutral rate cannot be touched, it cannot be seen. You have the freedom to adjust.

ECB president Christine Lagarde https://www.ecb.europa.eu/press/blog/date/2022/html/ecb.blog220523~1f44a9e916.en.html believes borrowing costs should be normalised “towards the neutral rate” if inflation is seen stabilising around 2% in the medium term. She did not estimate where neutral would be, or what the bank’s next steps should be.

Markets rates have been seen at over 1.8% by 2024. This is due to traders increasing their bet after an unexpectedly high May eurozone inflation print.

GRAPHIC: Markets bet ECB will hike interest rates fast Markets bet ECB will hike interest rates fast (https://graphics.reuters.com/EUROZONE-MARKETS/zdpxowdowvx/chart.png)

One size fits all

This discussion gives a peek at what the ECB is up against as it tries de-stress years of stimulus, while containing fragmentation risk – the division between wealthier and poorer states of the bloc that can be seen in diverging loan costs.

Villeroy and Kazimir called for neutral territory to be moved next year.

According to the latter, a rate of 1.5% is insufficient for taming prices. However, Fabio Panetta (an Italian board member) has cautioned that “normal” does not necessarily mean neutral in terms of policy.

Although inflation is the primary mission of the ECB, achieving neutral rates will not ease supply chains nor cut energy costs. However, it may worsen fragile economic prospects, according to Credit Agricole’s Louis Harreau, ECB watcher.

Harreau stated that “not only countries have differing neutral rates but also, on top of this, the transmission of monetary policy for all countries is not the same due to primarily sovereign spreads,” Harreau referred to the premium for countries with weaker credit ratings to borrow from Germany.

Allianz puts Germany’s neutral rates at 1.5%. That compares to 0.7% in Italy and 1.3% for all of the euro areas.

These divergences are due to below-potential output, lower productivity and greater debt levels in Southern European countries. The unemployment rates and inflation rates of member countries diverge widely. In the eurozone, inflation was 8.1% in May. It was 20% in Estonia while it was 5.6% in Malta.

Is this one-size fits all? Piet Christiansen from Danske Bank was the chief analyst for the euro zone neutral rate.

“Probably not, but it is one size does not fit all.”

GRAPHIC: Euro zone inflation is at record highs (https://fingfx.thomsonreuters.com/gfx/mkt/egpbkwxeovq/ecb0706.PNG)

DANGER?

Panetta of the ECB cautions against relying upon an unobservable rate of neutrality to direct policy. She recommends that there be a gradual reduction of stimulative measures during periods of high economic uncertainty.

Italy: UniCredit notes, assuming that Italy’s neutral rates are below 1.5%, that its three-year borrowing cost have risen to 2%. That means the economy could face restrictions as low interest ECB loans disappear.

Erik Nielsen is the bank’s chief economics adviser. He says that the ECB may lose control by ignoring previous references to observable financial conditions and instead focusing on neutral rates.

He explained that conducting monetary policies with an eye to the neutral rate was like driving through the desert looking for an oasis.