After months of pressure and political scandal, the UK government introduced a windfall tax on North Sea oil and gas at the end of May 2022.
But with recession risks clouding the horizon, how might increasing borrowing costs affect the eurozone economy and businesses across the bloc?
A stronger euroWhen central banks raise interest rates, the respective currency tends to rise. This is because investors get a higher return, so the currency becomes more appealing.
As the ECB increases interest rates, the single currency could strengthen. We may see it catch up against the pound and the US dollar, both of which have benefitted from more hawkish action from the Bank of England (BoE) and the Federal Reserve, respectively.
However, there are plenty of other factors that could negatively impact the euro, so a rally in EUR isn’t guaranteed.
FragmentationOne issue that could undermine the single currency, and could result from the ECB hiking rates, is fragmentation in the Eurozone.
What does fragmentation mean? Well, the Eurozone is made up of 19 separate countries, each with its own economy and financial system. As these economies are so different, they respond differently to monetary policy changes from the ECB.
As the ECB tightens policy this could create financial instability across the whole of the euro area, which could dent the Eurozone economy and pull the single currency apart.
Economists feel the ECB didn’t appropriately address this threat at its June meeting, which saw the euro slip – despite the bank’s fairly hawkish tone.
For businesses, this could create significant uncertainty and more difficult economic conditions in debt-stressed Eurozone countries, such as Greece, Italy and Spain.
Borrowing could fallHigher interest rates mean higher borrowing costs, and this could impact business and consumer behaviour.
A direct impact on business could be that loan repayments increase, thereby making it more expensive to finance projects. As a result, business investment and expenditure could decline.
Meanwhile, consumer spending could also fall as people prefer to save money rather than borrow or spend it. This means that business activity could slow for some companies.
Lower inflation?The main goal of higher interest rates is to lower inflation, and the ECB is hoping that it can bring soaring inflation closer to its 2% target. If it can, this would be great news for the Eurozone, where record price pressures are hammering households and businesses.
However, interest rates are a blunt tool at the best of times (and it certainly isn’t the best of times). Eurozone inflation is mainly being driven higher by surging energy costs, caused by a surge in post-pandemic demand and Russia’s invasion of Ukraine.
Raising interest rates won’t stop energy prices climbing, so some analysts are worried that inflation will keep going up despite the ECB’s best efforts.
Recession risksThere are fears that all these threats – fragmentation, slowing economic activity and stubborn inflation – could increase the likelihood of a recession.
The Eurozone economy is under significant pressure, not least from the Russia-Ukraine war and its impact on energy security. By applying the brakes on the economy, the ECB could tip it over the edge.
Protect against volatilityWhile many would argue that the ECB needs to raise interest rates – or perhaps should have done so sooner – it’s still potentially a risky move, posing another challenge to the Eurozone economy.
Investors and businesses need to pay close attention to how the move impacts individual countries in the euro area while also remaining vigilant for signs of a recession.
The single currency also faces uncertainty, and if you’re handling euros and other currencies then it may be prudent to develop a risk management strategy.
With specialist tools and expert guidance, you could protect your profits and benefit from more predictable cash flows. Get in touch to learn how Currencies Direct can help.
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