Image Source: Politico
The European Central Bank has announced the end of a long-running stimulus program and that it will raise interest rates for the first time since 2011 next month, with a possible greater 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 increase is expanding and may 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 1st, followed by a 0.25 percent interest rate hike later that month. However, it will raise rates again in September, and it may select for a larger rise – a 50 basis point hike, which would be the biggest one-time increase since June 2000. As economies emerged from Covid-19 lockdowns, oil and food prices drove rapid inflation, but Russia’s invasion of Ukraine has expedited these tendencies.
The amount of rate hikes to slow inflation has been hotly disputed by ECB policymakers, with Chief Economist Philip Lane favoring 25-basis-point increases in July and September, while others argue for 50-basis-point increases. To bolster their point, the ECB upped its inflation forecasts once further, now forecasting 6.8% inflation this year, up from 5.1 percent previously.
Following the statement, markets increased their expectations for rate hikes to 143 basis points by the end of the year, up from 138 basis points earlier, implying an increase at each meeting starting in July, with some moves exceeding 25 basis points. By the end of 2023, they expect a total of 230 basis points of movement in the deposit rate, bringing the interest rate peak to over 2%. This put Ms. Lagarde in an awkward position at her press appearance, considering she had just months previously warned that a rate hike this year was highly unlikely. Despite this, she was unafraid to say so, emphasizing several times how the bank expected to raise rates at subsequent sessions steadily.
She also promised that former eurozone debt crisis countries’ borrowing costs would not be pushed astronomically higher by financial markets. “We’re all in!” says the group, according to Ms. Lagarde.
The ECB’s first rate hike in over a decade will leave it behind most of its global counterparts, like 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 confirming their resolve to continue reinvesting cash maturing from the ECB’s $5 trillion in public and private debt.
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Ms. Lagarde has stated that interest rates should move toward a neutral threshold where the ECB is neither stimulating nor inhibiting growth. However, because this level is unknown and unobservable, markets are left guessing as to how far the ECB will go. Another uncertainty is how the ECB will deal with the disparity in borrowing costs among member states, something the ECB has said it will address but did not mention in its policy statement on Thursday.
The ECB’s one-size-fits-all monetary policy has already caused yields on government bonds in countries with higher debt loads, such as Italy, Spain, and Greece, to climb more rapidly than in countries with lower debt piles, such as Germany and France.