ECB to finally join rate hike club with big move on agenda

FILE PHOTO: A symphony of light consisting of bars, lines and circles in blue and yellow, the colors of the European Union, illuminates the south facade of the European Central Bank (ECB) headquarters in Frankfurt, Germany, Dec. 30, 2021. REUTERS/Wolfgang Rattay

FRANKFURT – The European Central Bank will raise interest rates for the first time in 11 years on Thursday with a bigger-than-flagged move seen as increasingly likely as policymakers fear losing control of runaway consumer price growth.

With inflation already approaching double digit territory, it is now at risk of getting entrenched above the ECB’s 2-percent target, requiring rate hikes even if that slows – or crashes – an economy already suffering from the impact of Russia’s war in Ukraine.

But policymakers appear far from united on just how fast the ECB should move with some arguing that it is already a long way behind the curve, especially compared to global peers like the U.S. Federal Reserve, while others point to a looming recession the ECB risks exacerbating.

The bank until recently was signaling just a 25- basis point increase to be followed by a bigger move in September but sources close to the discussion said a 50-basis point increase would also be on the table on Thursday as the inflation outlook is deteriorating quickly.

Economists polled by Reuters predicted only a 25-basis point increase but most said the bank should actually hike by 50 basis points, lifting its record low minus 0.5 percent deposit rate to zero.

Complicating the decision, the euro’s recent drop to a two decade low against the dollar also boosts inflation pressures, adding to the case for a bigger rate hike even if that ultimately hurts growth.

Shielding indebted nations

A larger increase would, however, require the ECB to shield more indebted nations like Italy or Spain from soaring borrowing costs, so a deal on a new bond purchase scheme, already close to being reached according to sources, would also be needed.

When rates rise, borrowing costs on the bloc’s periphery often increase disproportionately and the ECB has promised to fight this sort of fragmentation with a new instrument.

While not all the details of this tool are expected to be announced, ECB chief Christine Lagarde is likely to make a firm commitment and must offer financial markets at least some specifics including on the requirements for triggering ECB aid.

In June, when she made only a vague commitment, investors immediately challenged the ECB, pushing up Italian yields to their highest in a decade, forcing the ECB into a emergency policy meeting and a stronger pledge.

The ECB announces its policy decision at 1215 GMT, 30 minutes later than previously, while Lagarde’s news conference is scheduled for 1245 GMT, 15 minutes later than in the past.

Inflation vs recession

Along with the rate hike, the ECB is also set to signal a string of subsequent increases. It already flagged a 50 basis point hike for September and that is likely to remain on the cards.

It is also expected to pledge further moves, though it is less likely to make firm commitments.

“Our central case is for a 50 basis point hike in September, but we think … the Governing Council will leave the door open for a larger move,” BNP Paribas said in a note. “We still expect a … 50 basis point hike in October.”

Markets now see almost 100 basis points worth of moves by September and a combined 170 basis points of hikes by the end of the year, or increases at all four meetings, with several 50 basis point moves along the way.

The dilemma for policymakers will be to balance growth and inflation considerations.

Confidence has already taken a hit from the war and high raw materials prices are depleting purchasing power, pushing the block towards a possible recession, especially with looming gas shortages over the winter.

Raising rates in a downturn is controversial, however, and could magnify the pain as businesses and households face higher financing costs.

“One problem is that, for example, a gas shutdown would not only hit growth, but would also boost inflation and therefore the ECB may not immediately become more growth sensitive,” JP Morgan economist Greg Fuzesi said.

The ECB’s ultimate mandate is controlling inflation, however, and rapid price growth for too long could perpetuate the problem as firms automatically adjust prices.

Europe’s labor market is also increasingly tight suggesting that pressure from wages is also likely to keep price growth high.

Some central banks, most particularly the Fed, have made clear they are willing to crash growth to control inflation because the risk of a new “inflation regime” setting in is too high.

But if a recession is coming, the ECB needs to front load rate hikes so it gets done quicker.