Challenges for our economy in 2023

After the pandemic containment measures were lifted in the first half of the year, the economy initially picked up very quickly. This rapid growth and the sharp rise in energy and commodity prices due to the war in Ukraine resulted in an unprecedented 11.5% inflation rate. Energy-intensive businesses in particular, such as bakeries and greenhouse farms, saw their costs rise. Household purchasing power declined sharply, especially for lower-income households.

A slowdown in the economy was needed to get inflation under control, which meant the cooling down in the second half of the year came at the right time. The European Central Bank (ECB) started to accelerate the wind-up of its debt purchase programmes in 2022. The ECB also raised interest rates several times in the second half of the year to curb soaring inflation. The ECB’s inflation target is 2%. At the end of 2022, inflation was 9.2% in the euro area, and the ECB intends to raise interest rates for as long as necessary to bring inflation back down to the 2% target. More on this

The ECB has continued to raise interest rates in 2023. In March, the deposit rate now stands at 3%. These higher interest rates are needed to bring inflation down. They affect citizens, businesses, the government and central banks in various ways.

Banks must adjust to higher interest rates

After a long period of low interest rates where money was free, financial institutions are now having to adjust to a world of positive interest rates. Banks typically benefit from higher rates. However, banks with poor risk management can get into trouble, as we have seen in the US and Switzerland. This can have a negative impact on public trust in the sector. But today’s circumstances are very different from the situation during the financial crisis. Banks now have larger reserves and are better prepared for difficult times.

Higher interest rates drive down house prices

The 10-year mortgage rate (with National Mortgage Guarantee – NHG) rose from 0.9% to 3.9% in 2022. This marked a turning point for the overheated housing market. The higher borrowing rate, along with increased uncertainty and the cooling economy, caused house prices to fall month-on-month starting in mid-2022. This did not immediately lead to any problems, partly because the banks had established healthy reserves and because fewer interest-only mortgages are being issued these days. This makes houses less likely to go “underwater” when prices fall.  This does not mean first-time buyers now find it easier to purchase a house, however; financing a mortgage has in fact become more difficult for them. Furthermore, there is still a housing shortage housing shortage.

Higher interest rates boost funding ratio of pension funds

Higher interest rates resulted in higher funding ratios at pension funds. Although global stock exchanges performed poorly due to inflation and interest rates, pension funds saw their funding ratios rise to about 120% in 2022. Due to this and other factors, pension funds were able to resume indexation for the first time in years, a welcome boost to the purchasing power of older people.

Higher interest rates call for sufficient buffers in budget

Just like for a household, interest charges on past loans can haunt a country for a long time. Rising interest rates mean that borrowing has also become more expensive for the government. This makes it essential that the government once again musters the financial discipline to offset higher spending elsewhere in the budget. This is also necessary in view of the major challenges we are facing such as climate change, the energy transition, an ageing population and the need to create buffers to absorb future shocks.

Higher interest rates lead to losses for DNB

Higher interest rates mean we must pay more interest on the deposits commercial banks hold with us, while income from government bond holdings, a substantially larger asset as a result of the ECB's purchase programmes, does not rise in tandem. This will mean losses for DNB, which are expected to continue for several years and could even be so great that our buffer of over €11 billion will not be enough to absorb them.

The sharply increased prices are clearly having a big impact on our society. Central banks remain committed to beating high inflation. We will feel this in our economy and it will give rise to a number of key areas of concern this year.

Targeted government support

High inflation hits some groups in society disproportionately hard, and the call for income support for these groups is understandable. This support costs money, however, and an overly generous fiscal policy would boost inflation given the current supply-side tightness and make it harder for the central bank to bring inflation down. It is therefore important that government financial support is targeted to those who need it most, that it is temporary and that it is covered elsewhere in the budget.

Higher wages but no automatic price compensation

Higher wages can ease the pain of inflation-induced loss of purchasing power somewhat, especially in sectors with high labour productivity and profitability. Sectors badly affected by high energy prices may be better off with more moderate wage growth, however. Full and automatic wage hikes to compensate for inflation would increase the risk of a wage-price spiral. This could boost inflation further, and would therefore be unwise in any case.