The European Central Bank announced its biggest ever interest rate hike on Thursday. Its three key interest rates will be raised by 75 basis points in an attempt to control rapidly rising inflation in the eurozone. “The ECB has put its credibility on the line today.”
The ECB said the increase accelerates its monetary policy - “frontloading” in ECB language - in the transition from negative interest rates. When central bankers talk about frontloading, it means they want to bridge the gap between actual rates and those needed to keep inflation under control as soon as possible.
Wolfgang Bauer, fund manager at M&G’s Public Fixed Income Team, said that with the move, “the ECB has put its credibility as guardian of price stability in Europe on the line today”.
A rate hike doesn’t provide gas
“The ECB has opted for the biggest interest rate hike in its history,” Bauer said. “However, it is doubtful that advancing the normalisation process by today’s 0.75 percent step will have a tangible effect on inflation in the months ahead. Rising energy and other commodity prices are working their way into core inflation as higher input prices force companies to pass the pain - at least in part - on to their customers.”
“Much of this cost inflation is caused by supply shocks. It is very difficult to combat with monetary policy instruments. To put it bluntly, even the most ambitious interest rate increase by the ECB will not reopen Nord Stream 1. An energy price cap, as is currently being discussed in the UK, would probably be the most effective policy tool under these very special circumstances,” Bauer said.
The hawks are calling the shots
Simon Harvey, head of currency analysis at Monex Europe, said the ECB’s interest rate decision confirms that the hawks are currently calling the shots in the Governing Council, and that the ECB’s deposit rate is heading straight for the upper end of its estimated neutral range (1.5 percent - 2 percent) by the end of the year.
“We continue to count on a further 50 basis point increase in October and a reduction to 25 basis points in December,” said Harvey. “But, the risks remain that the trajectory will tighten in the near term and that rate hikes will continue through early 2023, when inflationary pressures will be at their greatest.”
The risks, he said, have been significantly heightened by today’s firm tone in President Lagarde’s press statement and question-and-answer session, in which she stated that the ECB will take larger steps because its interest rates are still far from the unspecified “neutral” range. The next meetings are scheduled for late October and December. The Governing Council meets every six weeks.
‘Currency market reaction is telling’
The reaction in the currency market to a more hawkish ECB decision is telling, said Harvey. For the euro, the confirmation of a 75 basis point increase sparked a brief rally.
However, with the deteriorating economic backdrop, the euro struggled to consolidate at its recent highs. These bearish assumptions were borne out during the press conference, with the euro dollar rate falling back to a low of 0.994.
“The real impact of the ECB’s rate change may not be felt in the euro until market risk appetite is better supported by a more neutral Federal Reserve and/or a period of sustained global disinflation,” said Harvey.
Two to five meetings needed
Lagarde said it will take between two and five meetings to bring eurozone rates to the required level. Asked about the size of these next increases, she said it will depend on economic data. If five meetings are needed, that would bring the ECB to early April, or around 30 March 2023, which is the date for the fifth Governing Council meeting from Thursday’s.
“We are determined to get this job done,” Lagarde said. “The further we are away (from the ECB targets), the bigger the step we take. That’s why we’re doing frontloading now. If there is a big supply shock, we will take that into account, both in terms of the impact on growth, and in terms of the impact on inflation.”
“Inflation is a terrible phenomenon, especially for the less privileged. We are all aware of that. Our task is to bring inflation down to 2 percent. We are determined to accomplish this task,” she said at the press conference.
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