The ECB has decided to raise interest rates for the first time in eleven years in an attempt to tackle persistent inflation. Asset purchases will also be halted from 1 July. The decision made in Amsterdam on Thursday marks the end of a long-standing period of monetary easing and negative interest rate policy.
Although food and energy prices still dominate European monetary depreciation, the ECB, through President Christine Lagarde, acknowledged that “inflationary pressures have intensified and are becoming broader, with the prices of many goods and services rising sharply”.
According to the ECB’s new projections, annual inflation will be 6.8 per cent for the euro area this year, but will decline thereafter to 3.5 per cent in 2023 and 2.1 per cent in 2024. That is significantly higher than March’s projections. Lagarde called the inflation outlook “undesirably high” and attributes this mainly to the conflict in Ukraine.
25 basis points
The ECB is ready to use all its current, and if necessary, new instruments to ensure that inflation stabilises at the 2 percent target in the medium term. The base rate will therefore be increased by 25 basis points in July and probably in September, according to the Governing Council’s unanimous decision. Although dependent on incoming data, the ECB expects that a gradual but steady further increase in interest rates will be appropriate.
Eleven years after ECB President Jean-Claude Trichet twice raised interest rates by 25 basis points, Christine Lagarde is following in his footsteps. In doing so, the eurozone central bank is taking the base rate out of negative territory for the first time since 2014.
“If our data continue to be disappointing, a bigger step will have to be taken in September to halt the devaluation,” Lagarde said, declining to quantify a possible next interest rate hike while alluding to a possible 50 basis point hike that some ECB watchers mentioned as an option.
Lagarde: “It is good practice to start with an incremental increase that is significant but not excessive. It is quite a journey, and we will see how the markets will react.”
Monetary easing ends
The ECB will also stop buying government and corporate bonds under the Asset Purchasing Programme (APP) on 1 July. This decision marks the end of the central bank’s monetary easing after seven years. The Frankfurt tailwind for the equity markets and Europe’s economy will thus start to die down next month.
“Maturing securities purchased under the APP will be reinvested for as long as necessary to maintain ample liquidity conditions and an appropriate monetary policy stance,” Lagarde said. “For the Pandemic Asset Purchase Programme (PEPP), maturing bonds will be reinvested at least until 2024.”
Wolfgang Bauer, a bond specialist at asset manager M&G, said the decision to end the purchase programme could cause additional market volatility. Without net purchases, markets have no safety net. This could lead to periods of increased volatility in the future.
Bauer: “However, given inflation, I think the bar is very high to go back on ending asset purchases. In my view, it would take a serious deterioration in economic fundamentals and an abrupt market correction to put asset purchases back on the agenda.”
Spreads
For the eurozone periphery in particular, rising interest rates will be harder to stomach as debt burdens will increase. The ECB will activate a special emergency programme to relieve the debt markets of weaker countries such as Italy and Greece in case investors turn their backs on them.
“The ECB will not tolerate any fragmentation that could hamper the transmission of monetary policy across the eurozone,” President Lagarde said at the press conference.
The interest rate spread between Italian and German 10-year bonds already widened to 2.08 percent this year before the ECB decision. On Wednesday afternoon, the spread reached 215 basis points, while a year ago it hovered around 1 percent.
Fragmentation risk
President Lagarde reiterated that the ECB stands ready to prevent fragmentation risks in the eurozone if necessary, without going into the details of such instruments. The verbal commitments and reinvestment of QE purchases remain the ECB’s preferred option until persistent bond yield spreads materialise.
According to Pietro Baffico, Europe economist at asset manager abrdn, the risk to investors of widening bond spreads remains despite the “new instruments” announced.
Andrew Mulliner, head of global aggregate strategies at Janus Henderson, said that “the lack of a clear approach to fragmentation poses significant risks to financial stability if it is not credibly addressed”. The surprisingly optimistic growth outlook, he said, suggests that today’s interest rate guidance may prove too optimistic as we move into the second half of the year.
This article originally appeared on InvestmentOfficer.nl.