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 greater boost in September if inflation continues to rise. With inflation at an all-time high of 8.1 percent and increasing, the ECB is concerned that price increase is expanding and could transform into a difficult-to-break wage-price spiral, ushering in a new era of persistently higher prices.
The eurozone’s 19 central banks have announced that bond purchases will halt on July 1, and 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 hike – a 50 basis point increase, which would be the greatest one-time increase since June 2000. Energy and food prices 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 inflation has been hotly contested by 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 European Central Bank boosted its inflation forecasts yet further, 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 every meeting since July, with some swings exceeding 25 basis points. By the end of 2023, they expect a total of 230 basis points of movement in the deposit rate, placing the interest rate peak close to 2%. Ms. Lagarde, who only a few months ago suggested a rate hike this year was doubtful, was caught off guard at her press conference. Despite this, she was unfazed, emphasizing several times how the bank steadily expected to raise rates at subsequent sessions.
She also promised that past euro zone debt crisis countries’ borrowing costs would not be driven drastically upward by financial markets again. “We’ve made a commitment, a commitment!” In addition, Ms. Lagarde stated the following.
The ECB’s first rate hike in more than a decade will still put 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, the ECB, unlike the Fed, has no intentions to decrease its balance sheet, with policymakers confirming their resolve to continue reinvesting cash maturing from the ECB’s 5 trillion euros in public and private debt.
According to Ms. Lagarde, rates should rise toward a neutral point where the ECB is neither stimulating nor inhibiting growth. However, because this threshold is undefined and unobservable, investors are left wondering how far the ECB is willing to go. Another uncertainty is how the European Central Bank would deal with the disparity in borrowing costs among member states, which the ECB said it might 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 to rise more quickly in countries with higher debt stacks, such as Italy, Spain, and Greece, than in less-indebted Germany or France.
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