The European Central Bank entered a new era on Thursday, as policymakers made clear that they planned to raise interest rates for the first time in more than a decade next month to tackle inflation.
To prepare for that move, the bank confirmed it would stop expanding its bond-buying program this month. After eight years, the bank’s negative interest rate policy and extensive asset purchase program are coming to an end, which has picked up billions of euros in government debt.
The end of those programs and the higher interest rates on the horizon are a reversal of years of policies that have tried to boost inflation and economic growth in countries that use the euro.
But recently, inflation across the eurozone surpassed economists’ expectations: the annual rate of price increases rose to 8.1 percent in May, the highest level since the introduction of the euro currency in 1999. Policymakers have been urged to act more quickly on inflationary inflation. forces stoked by the war in Ukraine.
“High inflation is a major challenge for all of us,” the bank said in a statement, as it warned that inflationary pressures had “broadened and intensified,” reaching more goods and services. Most goods and services used to measure inflation are rising by more than 2 percent, exceeding the central bank’s target. Inflation excluding food and energy prices, which tend to be more volatile, is also expected to exceed the bank’s target of 2 percent by 2024.
The central bank was explicit about raising rates, saying it plans to raise its three key interest rates by a quarter point at its July meeting, equating to minus 0.5 percent. The bank added that it expected to raise interest rates again in September. After that, there will be a “gradual but sustained path” of future increases, the bank said.
If the inflation outlook “continues or deteriorates,” the bank said, a larger rise in interest rates — likely half a percentage point — in September would be appropriate, although policymakers should determine whether such a move would apply to all policy rates. Raising interest rates by half a percentage point has become more common of late as prices rise rapidly around the world, with central banks in the United States, Canada and Australia opting for such a move.
For the eurozone, a half-point gain for July has been ruled out as it is “good practice” to start with a gain that is “significant, not excessive and points a path” that the central bank is on, Christine Lagarde, the bank’s president, reporters in Amsterdam told Thursday.
At the moment, the central bank deposit rate, which banks receive for depositing money with the central bank overnight, minus 0.5 percent, is actually a penalty designed to encourage banks to lend the money. instead of keeping it with the central bank. Interest rates were cut below zero for the first time in mid-2014 when inflation fell to zero.
“The European Central Bank is finally getting serious about tackling inflation risks,” Holger Schmieding, chief economist at Berenberg Bank, wrote in a note to customers, adding that the bank was taking a “harder line” than expected.
Shares in Europe fell, with the Stoxx Europe 600 index closing 1.3 percent lower. While traders had been betting on several rate hikes this year, government bonds also sold out, pushing their yields, which are a measure of borrowing costs, up. The euro fell against the dollar.
But not all analysts agreed that the bank was doing enough. Commerzbank analysts wrote that policymakers “acted too cautiously” and that inflation would be on average “well above” target in the coming years.
Valentin Marinov, currency strategist at Crédit Agricole, said the bank’s priority had shifted to tightening monetary policy and away from ensuring “favourable financial conditions,” a change that weighed on euro-denominated assets. This shift could also “increase market concerns about the growth prospects for the eurozone,” he said.
The central bank updated its forecast for the economy on Thursday, painting a grim picture of rising inflation and deteriorating growth prospects as the war in Ukraine disrupts trade and pushes energy and commodity prices up. Inflation is also depressing incomes, which is weighing on consumer confidence.
The war “has serious consequences for the euro area economy and the outlook is still surrounded by great uncertainty,” said Ms Lagarde. At the same time, China’s zero-covid policy is limiting production and exacerbating supply bottlenecks. “As a result, companies are facing increased costs and disruptions in their supply chains, and their prospects for future production have deteriorated,” she said.
The bank said the euro-zone economy is expected to grow 2.8 percent this year, slower than its previous forecast of 3.7 percent, and then 2.1 percent in 2023 and 2024.
The need to tackle inflation outweighs the bank’s concerns about a slowing economy. “Inflation will remain undesirably high for some time to come,” said Ms Lagarde.
This year, inflation will average 6.8 percent, up from 5.1 percent expected in March, before falling to 3.5 percent next year. In 2024, the bank forecast annual inflation to be 2.1 percent, still above the bank’s target of 2 percent, reinforcing the conditions for raising interest rates.
For most of the past decade, policymakers have struggled against under-inflation. The European Central Bank has tightened monetary policy more slowly than other major central banks in the United States and Britain, expecting the surge in inflation to be temporary and reverse relatively quickly as energy prices stabilize. In Europe, there were also fewer signs of second-round inflationary effects, such as workers demanding large wage increases in response to rising prices. But wage growth has begun to pick up in recent months, the bank said, and there are early signs that longer-term inflation expectations are beginning to rise above the bank’s target, something the central bank is keen to avoid.
As a harbinger of raising interest rates, the bank’s bond-buying program, a way to keep borrowing costs down and inject money into the system, will stop making net purchases by the end of the month, it said. policy makers. (A special pandemic bond-buying program ended in March after $1.7 trillion in purchases.) Before the program ends, the bank will buy $20 billion worth of mostly government bonds in June.
The bond-buying program began in 2015, and bank purchases have grown and dwindled as policymakers sought to warm and cool the economy as needed. In May, holdings in the program exceeded €3 trillion in bonds.
Officials will keep a close eye on the borrowing costs of highly indebted countries such as Italy if interest rates rise. The aim is to ensure that the interest rates they pay on their bonds do not deviate too much from those of other members in the bloc, such as Germany, so that countries in the single currency do not have to deal with various financial conditions that distort the effectiveness of monetary policy.
After Thursday’s policy meeting, the spread between 10-year government bond yields from Italy and Germany continued to widen to 2.16 percentage points, the widest since early 2020, as the onset of the coronavirus pandemic ravaged financial markets.
The bank said it would use the reinvestment of maturing bond proceeds in its bond-buying program during the pandemic, if necessary, to avoid this so-called market fragmentation.
There is no specific level of government bond yields or loan rates that would encourage the use of this flexibility, Ms Lagarde said, but the bank “will not tolerate fragmentation that would hamper the transmission of monetary policy.”
The bank’s reluctance to define the conditions that would trigger this flexible reinvestment policy means Italian bonds “are unlikely to find any comfort anytime soon,” Claus Vistesen, the euro-zone chief economist at Pantheon Macroeconomics, wrote in a note. On Thursday, the yield on Italian 10-year bonds rose 0.22 percentage point to 3.6 percent, the highest since the end of 2018.
June 9, 2022
An earlier version of this article misrepresented the European Central Bank’s forecast for economic growth in the eurozone this year. It forecasts growth of 2.8 percent for 2022, not 2.1 percent.
