Consumer prices in Europe are rising at the fastest rate in decades. Yesterday, officials in Frankfurt took a strong step to slow down inflation as worries about an economic slowdown grew.
In a move that hadn’t happened in more than a decade, the European Central Bank raised three of its interest rates by a half of a percentage point. This was twice as much as was expected, and it was similar to what the Federal Reserve and dozens of other central banks around the world did this year.
In the past few months, the global outlook has gotten worse because inflation is going up in almost every part of the economy and supply chains are still being messed up by pandemics. The outlook has been especially bad for the eurozone, which is the group of 19 countries that all use the euro.
The European Central Bank is dealing with a lot of uncertainty because war is getting closer and the cost of running businesses, heating homes, and feeding families is getting more and more expensive. Yesterday, Christine Lagarde, the head of the bank, didn’t say much about what will happen next.
Consumer prices in the eurozone went up an average of 8.6% from a year ago to last month. When inflation was this bad in the area before, there was no euro. This has put the European Central Bank in a place it has never been before.
Lagarde said at a news conference yesterday that inflation is still too high and is likely to stay that way for a while.
She said that the latest economic data show that growth is slowing, which makes it hard to predict what will happen in the second half of 2022 and beyond.
The central bank said it chose to “front-load” its rate increases because it was worried about Europe’s energy supply from Russia and because the economy was getting worse.
In one fell swoop, the bank ended eight years of negative interest rates. This was a policy that had been in place since 2014, when low inflation was a worry and banks needed to be encouraged to lend more.
The European Central Bank has moved more slowly to stop inflation than some of its international peers, like those in Britain and Canada. This is because it has been hit harder by sources of inflation that it can’t control, like Russia’s invasion of Ukraine, which caused disruptions in the global supply chain and higher energy prices.
Policymakers in Europe have also been more careful than those at the Federal Reserve in the U.S., where officials need to slow down the economy because of tight labour markets and strong consumer demand.
In a note, Wolfgang Bauer, a fund manager at M&G Investments, said, “The ECB’s monetary policy is still very different from that of other major central banks.”
The bank’s deposit interest rate is zero, but the key policy rate in Britain is 1.25 percent and the Fed’s is between 1.5 and 1.75 percent. “If inflation stays high, we still have a lot of work to do to catch up,” Bauer wrote.
Lagarde said that the decision to raise rates by twice what was expected at the last meeting was based on a “updated assessment of inflation risks.”
She also said that the bank’s approval of a new policy tool to stop “unwarranted” differences in borrowing costs between eurozone countries was another reason. These differences would make monetary policy less effective.
Inflation went up more than the bank had predicted in June, and the euro fell to the same value as the dollar for the first time in 20 years last week. This made inflation worse in the bloc because imports cost more because the value of the currency went down.
Even with the unexpected half-point increase, the bank is “moving much too slowly toward an interest rate level that is appropriate in light of high inflation,” Jorg Kramer, chief economist at Commerzbank, wrote in a note to clients.
The deposit rate, which is what banks get for putting money in the central bank, was raised from -0.5% to 0% by policymakers. The bank said that it is likely that rates will go up at future meetings, but that decisions will be made at each meeting based on the data.
The bank wants inflation to be 2% over the next few years, but it didn’t say anything about how big future increases might be.
Lagarde spent a lot of time at her news conference explaining all of the dark clouds that were gathering in the economy. Growth was slowing, the war in Ukraine was hurting growth, high inflation was making the cost of living go up, and businesses were facing higher costs and more problems with their supply chains.
But the central bank’s job is to keep prices stable, so lowering inflation must be seen as its top priority, even though price increases are all over the place. From about 6% in Malta to more than 20% in Estonia, inflation varies a lot.
Putting an end to the European Central Bank’s ultra-loose monetary policy, the next important step was to raise interest rates.
The bank has already stopped its programmes to buy bonds worth many trillions of euros. Thursday is when the new rates will take effect.
Yesterday, the bank also released a policy tool to keep borrowing costs from being too different among the 19 countries in the eurozone. It said this was one reason it could raise interest rates more than expected.
Investors were worried about the fiscal stability of the bloc’s most indebted members again because of the tightening of monetary policy.
Italy has the second-highest debt burden in the eurozone, and its borrowing costs have been going up quickly in recent months. This has made it more important to figure out if bond market moves are based on economic fundamentals or on speculative trading that threatens the effectiveness of monetary policy.
Yesterday, Mario Draghi, who was Lagarde’s predecessor at the central bank, quit as Prime Minister of Italy. This makes it harder to figure out what to think.
After 17 months, he lost control of the coalition government he had put together to make changes to the economy.
The Transmission Protection Instrument is the name of the bank’s new policy tool. Its goal is to stop government bond markets from moving in a chaotic way.
In short, the new tool will let the bank buy the bonds of countries where it thinks financing conditions are getting worse than they should.
But like a policy tool that was announced during the European debt crisis of 2012, there is hope that just announcing the tool will be enough to calm bond markets and that it won’t be needed.
The last time the bank raised rates was in July 2011. Just four months later, as a crisis in the region’s bond markets got worse, the move was reversed.
Right now, policymakers have to walk a fine line between easing price pressures and sending the European economy into a recession.
Analysts are wondering how high the bank can raise rates before the economy gets worse too much and the bank has to stop.
Lagarde said that the fact that the rate hike was bigger than expected didn’t change how high the bank expected to raise rates overall, but she didn’t say what rate the central bank wanted to reach.
Analysts at Commerzbank think that rates will peak in the spring at 1.5%.
More and more people are worried that the bloc will go into a recession, especially if natural gas supplies from Russia are cut off or if gas rationing slows down industrial production and stops rate hikes sooner than expected.
Thursday, the European Commission told its member countries to start limiting how much fuel they use right away to prevent energy shortages that would slow down economic growth and leave homes cold in the winter.
Nick Kounis, head of financial markets and sustainability research at ABN Amro, said, “A recession is coming, and the question is more about how bad it will be.”
“Right now, the focus is on inflation, but if the economy stops growing or even shrinks and unemployment starts to rise a lot, that could start to change the balance of risks.” New York Times
