The European Central Bank is raising interest rates by 75 basis points to encourage savings and reduce consumption for the first time in two decades.
Caught by record inflation, the European Central Bank (ECB) accelerated monetary tightening on Thursday by deciding to raise interest rates on an unprecedented scale.
The Board of Governors of the Monetary Institute decided to raise key interest rates by 75 basis points, the first in its two decades of existence – apart from a technical adjustment in 1999 July was cut from -0.5% to 0%, thus falling to 0.75%.
The other two key interest rates, the one for banks in multi-week refinancing operations and the one for the daily marginal lending facility, are 1.25% and 1.50%, respectively. Rate hikes should encourage savings and reduce consumption to ease price pressures.
Strong inflation for a long time
In July, the ECB had a firm hand announcing a surprise 50bp hike when 25bp was expected. This first surge in more than a decade came after a long period in which easy money helped boost the economy.
The promise then was to do the same in September provided inflationary pressures persist. However, euro-zone prices rose to a record 9.1% over a year in August, well above the ECB’s 2% target rate and urging it to send a strong signal on Thursday. The new tensions in energy prices since the Russian gas supply freeze to Europe even suggest double-digit inflation in the fall.
The hoped-for drop in prices will therefore be significantly increased by 2024, as the new inflation forecasts presented on Thursday show. The aggregate is set to rise to 8.1% by 2022, according to the ECB, before slowing to 5.5%. in 2023 and 2.3% in 2024.
GDP growth is still expected at 3.1% this year before slowing to 0.9% in 2023, much lower than the latest forecasts released in June.
More inflation and less growth: In this darkened context, the hard line advocated in particular by German Isabel Schnabel, an influential member of the ECB’s Executive Board, weighed on the decisions of the day.
It is important to show “determination” in the face of unbridled prices, and to do so “even at the risk of weaker growth and higher unemployment,” demanded Isabel Schnabel at the end of August. It is crucial that the public “retains confidence in our ability to maintain purchasing power,” she stressed. Until then, the dilemma between rising prices and recession fears has held back ECB action while other major central banks have started their rate-cutting cycle.
Within the Governing Council, a fraction of policymakers, led by chief economist Philip Lane, have defended a “gradual” approach to rate hikes. But this clan turned out to be in the minority despite the stack of alarming news piling up in the eurozone.
The euro’s weakness, falling below the $0.99 mark on Monday, could have provided another argument for a monetary hammer blow. A weak euro increases the cost of imported products, fueling inflation.
Federal Reserve rates are already between 2.25% and 2.50% and a 75 basis point hike is on the cards on September 21st. As for the ECB, observers say September’s tightening will call for more during the two meetings due before the end of the year. However, an aggressive interest rate policy by the ECB will tighten the credit conditions of countries in the euro zone that are considered vulnerable, such as Italy.
Sooner or later, the institute will probably have to resort to its new tool, which was presented this summer to nip speculative attacks on debt in the bud, according to Holger Schmieding, economist at Berenberg.