European Central Bank surprises markets with half-point rate hike

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The European Central Bank surprised investors with an interest rate hike half a point bigger than expected as it struggled to contain high inflation prompted by rising energy costs and the war in Ukraine.

The move – the ECB’s first rate hike in 11 years – came after officials signaled for weeks that they intended to raise rates by a quarter of a percentage point.

In a statement, the bank’s board said it acted on an “updated assessment of inflation risks” and said further such action was expected.

Today’s decision brings Europe’s main deposit rate down to zero after an extraordinary eight years in negative territory and comes as Europe’s monetary union grapples with pandemic, war and political upheaval.

Also on Thursday, Italy, the eurozone’s third-largest economy, remained mired in political crisis as Prime Minister Mario Draghi resigned following the collapse of his governing coalition.

The aggressive move by the ECB shows how global monetary authorities are shifting policy to deal with rising prices even as signs of a coming global recession mount.

In recent weeks, the Federal Reserve and the central banks of the United Kingdom, Canada, Switzerland, Australia and New Zealand have raised borrowing costs, in a bid to slow down their economies just enough to calm inflation – but not to the point of triggering a painful crisis. .

The policy change marks the abrupt end of a long era of easy money, which has fueled economic growth and sharp increases in the value of stocks, bonds and real estate in many of the world’s most advanced economies. world.

Speaking to reporters after the decision was made public, ECB President Christine Lagarde said an unexpected deterioration in the inflation outlook warranted a bigger rate hike. Inflation in the 19-nation euro zone hit 8.6% last month, the highest level in decades, from 8.1% in May.

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“We need to bring inflation down. … It’s time to deliver,” she said.

Natural gas prices in Europe have more than doubled since Russia invaded Ukraine on Feb. 24, raising costs for businesses and households on the continent and raising the specter of prolonged inflation.

“Pricing pressures are spilling over into more and more sectors,” Lagarde said. “We expect inflation to remain undesirably high for some time.”

ECB officials’ hopes of containing inflation hinge on an easing in energy costs and supply bottlenecks as well as the effects of rising interest rates, Lagarde said. Officials will decide on additional rate hikes on a meeting-by-meeting basis, depending on incoming economic data.

The ECB is due to meet for the next time on September 8.

European monetary officials are behind the Federal Reserve, which began raising interest rates in March and has already raised them three times, by a total of 1.5 percentage points.

Like its American counterpart, the ECB is struggling to contain rising prices without plunging the economy into recession. The challenge is particularly acute in Europe, where inflation is largely fueled by energy costs that rate hikes can do little to address.

“It’s a puzzle,” said economist Michael Strain of the American Enterprise Institute. “You want to lower overall price increases, but you have very little control over the real driver of inflation.”

The ECB’s baseline forecast does not foresee a recession either this year or in 2023, although Lagarde acknowledged that growth is slowing and the outlook is particularly uncertain.

ECB leaders also announced Thursday an agreement on a new monetary policy tool to prevent financial fragmentation in the euro bloc.

The 25-member Governing Council unanimously agreed to establish a new “transmission protection instrument” designed to smoothly transmit monetary policy decisions across all countries using the euro.

By activating the new instrument, the ECB could buy government bonds issued by eurozone members. The objective would be to “counter the unjustified and disorderly market dynamics” which threaten to break up the monetary union.

Lagarde declined to say whether the TPI could lead to purchases of Italian bonds by the central bank, whose yields have soared amid a week-long political crisis that is expected to lead to a snap legislative election.

As doubts grew over Italy’s future, investors demanded higher interest rates on Italian government bonds. The Italian government now has to pay 3.5% to borrow money from investors for 10 years, more than two percentage points more than Germany.

Even as the bank tried to fight rising prices, many analysts warned that a weakening European economy would likely force a quick halt to rate hikes.

The euro reached parity with the dollar this month, trading at an even 1-to-1 rate for the first time in two decades.

“There will be no touring bike for the ECB. The eurozone is in recession. The arrival [economic] contraction will make inflation old news,” Robin Brooks, chief economist at the Institute of International Finance, said on Twitter.

The eurozone banking system has already started to tighten credit.

European banks have become more picky about which borrowers they have lent to over the past three months, according to the ECB’s bank lending survey released this week. Business credit demand remains strong, but is driven by a need for working capital to meet rising costs rather than funds for new investments, according to the quarterly survey of 153 institutions.

Looking ahead, European banks said they expected “a moderate net decline in demand for loans”, the ECB reported.

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