ECB raises interest rates why the rate hike is just a start

ECB raises interest rates: why the rate hike is just a start

For the first time in more than a decade, the ECB has hiked interest rates again. What are the consequences? Why is that not enough for some experts? And why is Italy putting the central bank in a dilemma?

It is a milestone: After more than a decade of loose monetary policy, the European Central Bank (ECB) has decided to start tightening monetary policy and thus initiated the turnaround in interest rates. “We have decided to raise interest rates by 0.5 percentage points,” said ECB President Christine Lagarde in Frankfurt. At the same time, she announced further increases in key interest rates. The historic departure from loose monetary policy is also a farewell to penalties for commercial banks and zero interest rates for savers.

Stronger increase than announced

At the last ECB Council meeting in Amsterdam, the monetary authorities announced an increase of just 0.25 percentage points. Some experts were therefore surprised. “Personally, I was surprised that the ECB raised the key interest rate by 50 basis points because it announced 25 basis points more specifically than ever before in June,” says Emanuel Mönch, Professor of Monetary Policy and Financial Markets at the Frankfurt School of Finance & Management, in conversation with CityRyde.com. This is a clear signal that the ECB is now trying to get the curve under control in the fight against high inflation.

“The ECB Governing Council considered it appropriate to take a larger first step towards normalizing key interest rates than it announced at its last meeting,” the central bank explained its decision. It is based on the ECB Governing Council’s updated assessment of inflation risks.

For the former economist Volker Wieland, this is “a glimmer of hope” that the central bank is now raising interest rates faster than expected. Because the increase “comes too late and is not enough to effectively combat inflation,” the professor of monetary economics at the Goethe University in Frankfurt told CityRyde.com. Inflation expectations have risen much more sharply in recent months, so real interest rates are still lower.

Inflation at historic highs

“The ECB failed to react to the increase in inflation. It was already foreseeable in spring 2021 that it would rise significantly. Even then, the ECB should have adjusted its very loose monetary policy,” Wieland told Hessischer Rundfunk. Because it didn’t, it contributed to inflation and expectations climbing higher. The Ukraine war and the exploding energy prices were only a “fire accelerator.” “The ECB is reacting much too late and too cautiously.”

In view of the record inflation in the eurozone, other experts have also called for an even greater increase in key interest rates. In June, consumer prices in the euro area were 8.6 percent higher than in the same month last year. For 2022 as a whole, the EU Commission estimates an average inflation rate of 7.6 percent in the currency area of ​​the 19 countries – a historic high.

The inflation rate is thus well above the annual target of two percent that the ECB is striving for. Higher inflation reduces the purchasing power of consumers because they can afford less than one euro. The drivers of inflation have been significantly higher energy and food prices for months. The Russian war of aggression in Ukraine has made the situation even worse.

Far behind compared to other central banks

Critics have long accused the ECB of initiating the turnaround in interest rates much too late. “Compared to other central banks, the ECB is far behind in the rate hike cycle,” explains expert Mönch. It was now her duty to react quickly “in order to get the inflation under control to some extent.” For comparison: The US Federal Reserve, for example, has raised interest rates to the current range of 1.5 to 1.75 percent since the spring. The rate hike in June alone was 0.75 percent, making it the highest jump since 1974. In Canada, monetary authorities even raised the key interest rate by a full percentage point.

However, the ECB is not exactly having an easy time either: Because of the current energy crisis, the interest rate hike actually comes at the wrong time, says Christina Bannier, Professor of Finance at the University of Giessen, in an interview with Hessischer Rundfunk: “On the one hand, we have the enormously growing inflation rate, on the other hand, the danger of a recession or a sharply weakening economy.” The former speaks for more aggressive interest rate increases, and the latter for lower interest rates to support the economy.

Because high interest rates continue to choke off the weak economy, according to economic theory, because investments for companies are becoming more expensive, and private consumption is weakening due to more expensive loans. It is, therefore, understandable for Bannier that the ECB, unlike other central banks around the world, is proceeding much more cautiously.

Read also: Consumer prices: Inflation and no end?

ECB is in a dilemma

Mönch from the Frankfurt School of Finance & Management also sees this dilemma: “It’s a very difficult situation for the central bank. Some of these price drivers have little to do with demand effects.” Instead, the economy is more likely to be burdened on the supply side: by supply chain bottlenecks as a result of the pandemic or the Ukraine war, which is affecting energy prices. Traditionally, a central bank can do little there.

In addition to the weak euro, which makes imports more expensive and further fuels inflation, there is also a high level of debt in southern European states, for which interest rates that are raised too quickly can become a burden. “The long low interest rates have not been used well enough by some European countries to reduce their debt ratios,” says Mönch. There is great skepticism in the financial markets as to how these countries can survive the turnaround in interest rates.

Because the decision to end bond purchases and the announcement of the interest rate hike in June had already pushed up yields there. In order to support the heavily indebted states in the event of turbulence in the bond market, the monetary watchdogs have now agreed on a new crisis bond purchase program. Work on it had already been accelerated in June.

New anti-crisis tool

The new tool, “Transmission Protection Instrument” (TPI), should help to ensure that monetary policy can have an even effect in the euro area and that the financing costs of the individual euro states do not diverge. The yield gap – the spread – between government bonds from Germany and those of more indebted euro countries, especially Italy, had widened recently. In other words, for countries like Italy, where the government crisis is making the markets even more nervous, it will be more expensive to get fresh money.

However, the uniformity of the Governing Council’s monetary policy is a prerequisite for the ECB to be able to fulfill its price stability mandate, the central bank said. TPI was created for special situations and risks that could affect every country in the eurozone. If necessary and depending on certain indicators, the Governing Council will decide whether the program will be activated for a country and what the scope will be. In addition, it is linked to several conditions, such as debt sustainability.

“I fear that the ECB will not be able to avoid using the program,” explains expert Wieland. Expectations are very high, and especially in Italy, investors would demand a high premium in the government crisis. He sees TPI as “highly problematic.” After all, it is normal for more heavily indebted countries to have to pay higher interest premiums on the market when they tighten. In addition, the central bank has largely undermined the market in the past two years with its pandemic emergency purchase program, so the premiums of the past two years do not reflect a market premium.

TPI will apparently not be used in the Italian case for the time being

Expert Mönch, on the other hand, can understand the ECB a bit: “The central bank has to make monetary policy for all member states and ensure that the interest rate decision reaches all countries. If there is turbulence in the financial markets, effectiveness can be limited.” It is unclear whether the new instrument will actually calm the situation. If the crisis in Italy worsens, the ECB may have to spend a lot of money to artificially lower interest rates on Italian government bonds.

“The proportionality of the measure with regard to its primary goal of maintaining price stability, which the Federal Constitutional Court has demanded, could then become a tightrope walk,” says Mönch. In summary, it is both economically and legally difficult. Whether the ECB is already using TPI in the current situation around Italy is an open question. According to insiders, an operation is not imminent because the conditions would not warrant it, several people familiar with the situation told Reuters.

Irrespective of the new purchase program, further interest rate steps are to follow in the future. “Further normalization of rates will be appropriate at our next rate meetings,” Lagarde said. By bringing forward the exit from negative interest rates, the monetary authorities could also switch to interest rate decisions being made from one meeting to the next. “We will proceed month by month and step by step,” said Lagarde. The future path will depend on the data situation. Many economists are assuming that the interest rate will have risen to as much as 1.5 percent next spring

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