After 300 basis points in six subsequent rate hikes since last July, the European Central Bank on Thursday stopped talking about further increases in eurozone interest rates. The ECB is unsure about its next steps now the effects of higher rates are being felt by businesses, households and banks. It also sees that its policy is transmitting “rather rapidly” into the economy.
The ECB announced, as expected, a 50 point increase in its benchmark interest rates, before saying its next steps would be based on analysis of forthcoming data. The hike brought its main refinancing rate to 3.5%, the highest since October 2008.
ECB President Christine Lagarde presented three criteria the ECB will use going forward. These criteria are “brand new” and were “never discussed” before, she said. This approach also gives the ECB time to assess the effects of this month’s market turmoil, including the collapse of Silicon Valley Bank and tumultuous days for Swiss bank Credit Suisse.
“It is not possible at this point in time to determine what the path will be going forward,” Lagarde said. “As to the future, we would be data dependent. Elevated uncertainty has reinforced the importance of a data-dependent approach. We need to have a better assessment once the financial tensions in the market abate. We’re going to really look at the uncertainty fading out, we hope.”
Three data components
The three components the ECB will use for determining its next steps are the assessment of the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission in the eurozone. These factors will determine its next rate move, due to be announced on 4 May.
Lagarde suggested this month’s widespread global turmoil in financial markets will not be considered on its own merits, but that its impact will be reviewed as part of the ECB’s assessment of the inflation outlook. “Financial issues are captured” in the first component, she said.
The ECB on Thursday lowered its overall inflation projection for the next three years, but increased its outlook for the underlying rate for this year because it sees resilient labour markets and strong wage growth. The cut-off point for making these projections were 15 February and 1 March, well ahead of the recent financial turmoil.
Transmission mechanism
The “level of uncertainty is completely elevated as a result of that,” Lagarde said.
During her press conference, Lagarde shared some insights on an internal reflection at the ECB about the transmission mechanism of monetary policy which indicate that the ECB is surprised about the speed with which its higher interest rates are filtering into the economy. The ECB is preparing a speech in which she will address the primary and secondary effects of policy transmission. Data on business lending, household lending, mortgages shows that commercial banks were quick to pass on higher rates to their clients.
‘Transmitted rather rapidly’
Monetary policy “seems to have transmitted rather rapidly to the credit sector,” Lagarde said, adding that this has made bank credit and household borrowing in the euro area more expensive, weakened loan dynamics, and led to a decline in demand for loans, effectively braking economic growth.
Data on bank lending shows that, as a result of higher rates, eurozone banks have significantly tightened their credit standards, making loans more expensive for borrowers. In January, the ECB said banks during the fourth quarter substantially raised their approval criteria for loans to firms and households, due to higher risk perceptions, declining risk tolerance and increased funding costs. Banking tightening during the fourth quarter stood at its highest levels since the eurozone debt crisis in 2001.
A new ECB Bank Lending Survey is due to be released on 2 May, just ahead of its next interest decision.
The rapid rise in interest rates since last summer, in Europe as well in the US, now clearly is affecting the economy. Financial accidents like the collapse of Silicon Valley Bank in the US also make clear that higher rates are now building pressure in different parts of the economy.
Crisis ‘in context not surprising’
‘It is remarkable how quickly, how stark the change has been in rates,” said Charles-Henri Kerkhove, Fidelity’s investment director solutions and multi-asset, speaking at a Brussels conference earlier this week. “Mini-crises like that over the weekend always come up as a surprise. In context, it is not surprising. We should see more of those over time.”
Back in Frankfurt, Lagarde reiterated the ECB’s confidence in the Eurozone banking sector, speaking about resilience and strong capital and liquidity positions. “The banking sector currently is in a much much stronger position than it was in 2008. Added to that, if it were needed, we do have the tools that are available, we do have a toolbox” to act if necessary.
Lagarde repeatedly referred to the “creativity” of the ECB staff to come up with innovative solutions to solve unexpected problems if they emerge during special circumstances. “This is not what we are seeing.”