August 13, 2022

ECB raises rates more than expected to fight runaway inflation

  • All rates will increase by 50 basis points
  • Inflation is uncomfortably high and rising
  • The ECB also approves an ‘anti-fragmentation’ instrument called TPI
  • Press conference at 1245 GMT

FRANKFURT, July 21 (Reuters) – The European Central Bank raised interest rates more than expected on Thursday, confirming concerns about runaway inflation are now on the horizon as the euro zone economy reels from the impact of Russia’s war in Ukraine.

The ECB raised its benchmark deposit rate by 50 basis points to zero percent, breaking its own guidance for a 25 basis point move, joining global peers in raising borrowing costs. It was the first interest rate hike by the euro zone central bank in 11 years.

Ending an eight-year experiment with negative interest rates, the ECB raised its key refinancing rate to 0.50% and promised further rate hikes at its next meeting on September 8.

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“Further normalization of interest rates would be appropriate,” the ECB said. “The pre-hike exit from negative interest rates allows the Governing Council to transition to a meeting-by-meeting approach to interest rate decisions,” the ECB said in a statement.

The ECB for weeks had guided markets to expect a 25 basis point increase, but 50 basis points was in play as sources close to the debate indicated a further deterioration in the inflation outlook ahead of the meeting.

With inflation already nearing double-digit territory, it is now at risk of sticking above the ECB’s 2% target and gas shortages in the coming winter could push prices higher, sustaining rapid price growth.

Economists polled by Reuters had forecast an increase of 25 basis points, but most said the bank would actually need to increase by 50 basis points, after its record low minus 0.5% raised the deposit rate to zero. read more

The euro, which fell to a two-decade low against the dollar earlier this month, firmed by around half a percent at the ECB’s conclusion.

The ECB agreed to provide more aid to the most indebted countries of the 19-nation bloc by approving a new bond-buying scheme, the Transmission Protection Instrument, aimed at curbing the rise in their borrowing costs.

“The extent of TPI purchases depends on the severity of risks facing the policy exchange,” the ECB said in a statement. “The TPI will ensure the smooth transmission of monetary policy stance across all euro area countries.”

When ECB rates rise, borrowing costs in countries like Italy, Spain or Portugal increase proportionately as investors demand a bigger premium to hold their debt.

The ECB’s assurance on Thursday comes as the political crisis in Italy is already weighing on markets following the resignation of Prime Minister Mario Draghi.

The yield between Italian and German 10-year bonds briefly crossed 240 basis points on Thursday and is not far from the 250 basis points that prompted an emergency ECB policy meeting last month.

Markets now turn to ECB President Christine Lagarde’s 1245 GMT news conference.

Inflation VS Depression

The ECB’s 50 basis point hike on Thursday lags behind its global peers, particularly the US Federal Reserve, which raised rates by 75 basis points last month and is likely to move by a similar margin in July.

But the eurozone is increasingly exposed to the war in Ukraine and a threatened cut in gas supplies from Russia that could push the bloc into recession, leaving policymakers in a dilemma of balancing growth and inflation considerations.

Confidence has already been affected by the war, and high raw material prices are reducing purchasing power.

Raising borrowing costs in the fall is controversial, however, and could magnify the pain for businesses and households.

But the ECB’s final mandate curbs inflation, and as firms adjust prices automatically, rapid price growth may continue to be problematic in the long run.

Europe’s labor market is also increasingly tight, which means pressure on wages is likely to keep price growth high.

Some central banks, particularly the Fed, have made it clear that they are willing to slow growth to curb inflation because the risk of setting up a new “inflationary regime” is too high.

And if a recession comes, the ECB should raise the front-load rate so that its tightening cycle ends sooner.

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Editing by Toby Chopra, John Stonestreet and Catherine Evans

Our Standards: Thomson Reuters Trust Principles.