Image Source: Politico
The European Central Bank has terminated a long-running stimulus program and said it would raise interest rates for the first time since 2011 next month, with a possible more significant boost in September if inflation does not moderate. With inflation at an all-time high of 8.1 percent and increasing, the ECB is concerned that price rise is widening and could transform into a difficult-to-break wage-price spiral, ushering in a new era of stubbornly higher prices.
The eurozone’s 19 central banks have announced that bond purchases will halt on July 1 and that interest rates will be raised by 0.25 percent later that month. However, it will raise rates again in September and may opt for a larger rise – a 50 basis point hike, which would be the greatest one-time increase since June 2000. Energy and food prices originally drove the quick rise in inflation as economies emerged from Covid-19 lockdowns, but Russia’s invasion of Ukraine has expedited those trends.
The amount of rate hikes to slow price growth has been hotly contested among ECB policymakers, with Chief Economist Philip Lane favoring 25-basis-point increases in July and September, while others argue that 50-basis-point increases should be considered. In support of their position, the ECB boosted its inflation forecasts again, now forecasting 6.8% inflation this year, up from 5.1 percent previously.
Following the statement, markets moved to price in 143 basis points of rate hikes by the end of the year, up from 138 basis points earlier, or an increase at each meeting starting in July, with some swings exceeding 25 basis points. They also expect a total of 230 basis points of deposit rate movement by the end of 2023, placing the interest rate peak close to 2%. This put Ms. Lagarde in a difficult position at her press conference, given she had previously stated that a rate hike this year was quite unlikely. Despite this, she exhibited no trepidation, emphasizing several times how the bank steadily expected to raise rates at subsequent sessions.
She also promised that former eurozone debt crisis countries’ borrowing costs would not be driven drastically higher by financial markets. “We’ve made a commitment, we’ve made a commitment!” Ms. Lagarde explained.
The ECB’s first rate hike in over a decade will still put it behind most of its global rivals, such as the US Federal Reserve and the Bank of England, which have been raising rates aggressively and promised even more action. However, unlike the Fed, the ECB has no intentions to decrease its balance sheet, with policymakers reiterating their determination to continue reinvesting cash maturing from the ECB’s 5 trillion euros in public and private debt.
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Ms. Lagarde has stated that interest rates should move towards a neutral threshold where the European Central Bank is neither stimulating nor inhibiting growth. However, because this threshold is indeterminate and unobservable, markets are left wondering how far the ECB will go. Another uncertainty is how the ECB would deal with the disparity in borrowing costs among member states, which it suggested it might address but did not mention in its policy statement on Thursday.
Government bond yields have risen more quickly in Italy, Spain, and Greece than in less-indebted Germany or France, posing a problem for the ECB’s one-size-fits-all monetary strategy.