September 30, 2022

The European Central Bank promises more rate hikes after an unprecedented increase

The European Central Bank promises more rate hikes after an unprecedented increase

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  • Raise the interest rate on deposits from zero to 0.75%
  • Inflation in the euro area is uncomfortably high and rising
  • New ECB forecasts show higher inflation and lower growth
  • More price hikes have been reported
  • The downward growth scenario is already happening

FRANKFURT (Reuters) – The European Central Bank raised key interest rates by an unprecedented 75 basis points on Thursday and promised more increases, prioritizing fighting inflation even as the European bloc likely headed toward a winter recession and gas rationing.

With inflation soaring to its highest level in half a century and approaching double-digit territory, policymakers worry that rapid price growth is becoming entrenched, melting household savings, discouraging investment, and unleashing a hard-to-break spiral in wage prices.

In the wake of the July rate hike, the European Central Bank raised the deposit rate to 0.75% from zero and raised the key refinancing rate to 1.25%, the highest for both since 2011, with promised moves for the next several meetings.

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However, the European Central Bank lags behind many of its peers, notably the US Federal Reserve, in raising interest rates and some analysts see the huge steps since July as an attempt to catch up.

“We expect interest rates to be raised further, because inflation is still very high and is likely to remain above our target for a long time,” European Central Bank President Christine Lagarde said, adding that Thursday’s decision was unanimous.

“We think it will take several meetings,” she said. “How many? It might be more than two, including this one, but it’s also likely less than five,” Lagarde said, suggesting that the price hike could continue into early 2023.

Reuters graphics

Policy makers have been swinging for weeks between 50 and 75 basis points, but another jump in both headline and core inflation is likely to have settled the argument with Lagarde repeatedly arguing that the current high is simply not acceptable.

When asked about future moves, Lagarde said 75 basis points is not the norm and future moves may be smaller, but she also refused to rule out a similarly large move in the future.

“We still expect the deposit rate to rise to 1.75% by the beginning of next year, but the rate hike will be paused after that due to the recession that will be visible after that,” said Joerg Kramer, economist at Commerzbank.

“In order to permanently rein in inflation, the ECB will have to go above and beyond, because inflation is significantly above its target,” Kramer added.

Reuters graphics

Inflation jumped to 9.1% in August and the European Central Bank’s new forecast expects a peak near that level just before the end of the year, even if some market analysts see it over 10% soon.

However, this forecast puts price growth above the bank’s 2% target for years to come with the 2023 forecast rising to 5.5% from 3.5% and 2024 at 2.3%, above the 2% target.

Markets, which saw Thursday’s move as highly likely, are now pricing in just over 50 basis points in October and a similar hike in December.

“What we are is not price neutral,” Lagarde said. “We’re going in that direction. It takes a front-loading. It’s going to take more hikes in the next several meetings.”

The European Central Bank’s growth forecast, which has been cut sharply for next year, predicts an economic stagnation during the winter months, but many potential downside risks, notably the loss of Russian gas, have already materialized.

Reuters graphics

“We see today’s decision in favor of the bigger move as a signal to markets that the central bank is serious about restoring its anti-inflation credentials and is willing to accept the costs in terms of lower growth to ensure price stability,” Morgan Stanley said in a note.

In the ECB base scenario, the economy is expected to expand by 0.9% next year while on the downside, it may contract by 0.9%.

However, this downside scenario would push inflation higher, to 2.7% in 2024 as the drag caused by the economic downturn will be far outweighed by persistently high natural gas prices.

EUR weakness may have been taken into account on Thursday.

The euro has been parity against the dollar for weeks, and its sharp drop to two-decade lows this year has increased import costs and increased inflation.

Lagarde added that while her huge balance sheet is rotating, as some of her peers have done, it may be on the agenda at some point, she is now focusing on interest rates as a tool.

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(Reporting by Balach Kuranyi and Francesco Canepa) Editing by Hugh Lawson

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