August 16, 2022

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The European Central Bank raises interest rates more than has been reported in the race to tame inflation

The European Central Bank raises interest rates more than has been reported in the race to tame inflation

  • All prices go up by 50 basis points
  • Inflation will remain ‘undesirably high’
  • The European Central Bank supports the “anti-fragmentation” tool called TPI
  • Lagarde says the ECB “could be a big hit”

FRANKFURT (Reuters) – The European Central Bank raised interest rates by more than expected on Thursday as concerns about hyperinflation outweighed concerns about growth, even as the euro zone economy grappled with the impact of the Russian war in Ukraine.

The European Central Bank raised its benchmark deposit rate by 50 basis points to zero per cent, breaking its guidelines for a 25 basis point movement as it joined with its global peers in raising borrowing costs. This was the first ECB rate increase in 11 years.

Policy makers also agreed to provide additional assistance to the most indebted countries in the 19-nation currency bloc – including Italy – through a new bond-buying scheme aimed at curbing rising borrowing costs and thus limiting financial fragmentation.

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Ending an eight-year experiment with negative interest rates, the European Central Bank also raised its key refinancing rate to 0.50%, promising further increases, possibly once it meets on September 8 with more later.

European Central Bank President Christine Lagarde said the apparent deterioration in inflation expectations and collective support for the anti-retail instrument justified the larger move.

“Price pressure is spreading across more and more sectors,” Lagarde said. “We expect inflation to remain undesirably high for some time.” It cited driving factors including rising food and energy costs and rising wages.

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“We decided on a balanced basis that it was appropriate to take a larger step towards exiting negative interest rates.”

But Lagarde said that even if the ECB is now moving more quickly, the final interest rate – or the level at which the hikes end – remains unchanged.

The European Central Bank did not provide guidance on the expected interest rate hike in September, saying only that additional increases would be appropriate and decisions would be made at the meeting.

The European Central Bank had directed markets for weeks to expect a 25 basis point increase on Thursday, but sources close to the discussion said 50 basis points came into effect shortly before the meeting as part of a deal that includes aid for heavily indebted countries.

With inflation already near double-digit territory, it is at risk of solidifying above the European Central Bank’s 2% target, with any gas shortages over the coming winter likely to push prices higher, perpetuating rapid price growth.

Lagarde warned that risks to inflation expectations were to the upside and intensified, especially as the war is likely to continue, keeping energy prices high for longer.

Economists polled by Reuters had expected an increase of 25 basis points but most favored a 50 basis point increase, bringing the European Central Bank’s record low deposit rate of minus 0.5% to zero. Read more

The euro rose 0.8% to $1.0261, having traded at $1.0198 just before the statement but turned negative today as Lagarde spoke. Markets are now pricing in a rate hike of about 50 basis points in September and a combined 124 basis point hike through the rest of the year.

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Will you get bigger?

The new bond-buying scheme, called the Transfer Protection Instrument (TPI), aims to curb rising borrowing costs across the currency bloc as policy tightens.

“The volume of TPI purchases depends on the severity of the risks to the policy transition,” the ECB said in a statement. “TPI will ensure that the monetary policy stance is transmitted smoothly across all eurozone countries.”

As ECB rates rise, borrowing costs increase disproportionately for countries such as Italy, Spain or Portugal as investors demand a higher premium for holding their debt.

“The European Central Bank is able to do a great job of that,” Lagarde said.

The activation of the instrument will be entirely at the discretion of the European Central Bank and the bank will target public sector bonds with maturities between one and 10 years.

Countries will be eligible if they comply with EU fiscal rules and do not experience “severe macroeconomic imbalances”. Compliance with commitments under the EU’s Recovery and Resilience Facility, as well as debt sustainability assessment, will be required.

Thursday’s ECB commitment comes as Italy’s political crisis is already weighing on markets following the resignation of Prime Minister Mario Draghi, who was Lagarde’s predecessor at the ECB.

The yield spread between Italian and German 10-year bonds widened to 246.5 basis points during Lagarde’s press conference, not far from the 250 basis points level that triggered an emergency European Central Bank policy meeting last month.

The European Central Bank’s 50 basis point hike still leaves it lagging behind its global peers, notably the US Federal Reserve, which raised interest rates by 75 basis points last month and is likely to move by a similar margin in July.

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But the eurozone is more vulnerable to war in Ukraine, and the threat to cut gas supplies to Russia could push the bloc into recession, leaving policymakers with a dilemma over balancing growth and inflation considerations.

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Written by Mark John. Editing by Toby Chopra, John Stonestreet and Catherine Evans

Our criteria: Thomson Reuters Trust Principles.